February 13, 2008
LMSB Control No: LMSB-04-0108-001
Impacted IRM: 4.51.2
MEMORANDUM FOR INDUSTRY DIRECTORS
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR, INTERNATIONAL COMPLIANCE STRATEGY
AND POLICY
FROM: Sergio Arellano /s/ Sergio Arellano
Industry Director, Retailers, Food, Pharmaceuticals, and Healthcare
SUBJECT: Tier 1 Issue - Industry Director Directive on Section 936
Exit Strategies #2
Introduction:
On Feb. 2, 2007, the Industry Director for Retailers, Food, Pharmaceuticals, and Healthcare issued an Industry Director’s Directive on Section 936 Exit Strategies (Exit Strategies #1). This directive (which we shall refer to as Exit Strategies #2) supplements Exit Strategies #1 by focusing on the section 367 issues that arise out of the restructuring of section 936 corporations.[1]
This directive is intended to provide a uniform format and approach for examiners to evaluate potential compliance risk related to this issue and to outline the issue management and oversight process that has been established. This directive is not an official pronouncement of law or the position of the Service and cannot be used, cited, or relied upon as such.
Background:
The following is a summary of the information contained in Exit Strategies #1 so as to provide background information for the discussion of the section 367 issues arising out of the restructuring of section 936 corporations.[2]
Section 936 provided a tax credit against US taxes imposed on income earned by a US corporation (usually referred to as the Possession Corporation), from the active conduct of a trade or business in Puerto Rico. Under a typical structure, the Possession Corporation was a wholly-owned US subsidiary of another US corporation (usually referred to as the US Parent). As a result of the ten-year phase out of the section 936 credit (1995 – 2005), many taxpayers began restructuring their section 936 corporations in order to preserve the historically low levels of taxation under section 936. These restructurings began for some taxpayers around 1999 and continued through 2006.
Most restructurings of section 936 corporations involve transfers of assets under section 351 or section 361. The most common form of such restructurings is as follows:
Step 1: The Possession Corporation (or the US Parent, which owns 100% of the Possession Corporation) sets up a new controlled foreign corporation (CFC) in a low tax jurisdiction (such as Cayman Islands or Bermuda).
Step 2: The Possession Corporation transfers all of its manufacturing assets located in Puerto Rico to the new CFC as a non-taxable contribution to capital under section 351 or as part of a non-taxable reorganization under section 361. (After this transaction, the Puerto Rican assets of the former Possession Corporation function as a manufacturing branch of the CFC.)
Step 3: The new CFC enters into a license agreement with the US Parent that allows the CFC to use the US Parent’s manufacturing intangibles in the CFC’s manufacturing operations.
The facts described above in Step 2 raise a number of section 367 issues. (Step 3 does not generally raise section 367 issues because that step involves a licensing transaction that is usually governed by section 482.) Section 367 applies when a domestic corporation transfers assets to a foreign corporation in a transaction involving sections 351 or 361. Section 367 applies to Step 2 because a domestic corporation, the Possession Corporation, transferred its assets to a foreign corporation, the CFC, in a transaction involving section 351 or section 361.
Most of the controversial issues involving section 367 in 936 reorganizations involve transfers of intangible assets under section 367(d).[3] Generally, the outbound transfer of intangibles requires compensatory payments to the US transferor pursuant to § 367(d)(2). The type of intangible property covered by this rule is that described in IRC § 936(h)(3)(B). The rule requiring compensation to the US transferor does not apply to the transfer of “foreign goodwill or going concern value”. Reg. § 1.367(d)-1T(b). Reg. § 1.367(a)-1T(d)(5)(iii) provides, that [f]oreign goodwill or going concern value is the residual value of a business operation conducted outside of the United States after all other tangible and intangible assets have been identified and valued. For purposes of section 367 and regulations thereunder the value of the right to use a corporate name in a foreign country shall be treated as foreign goodwill or going concern value.
The definition of foreign goodwill or going concern value therefore makes it important that all other tangible and intangible assets be identified and valued.
A taxpayer may claim that transfers from the § 936 corporation include a significant amount of value in the form of workforce-in-place and that such workforce-in-place is not taxable. Workforce-in-place is properly treated as an intangible under § 936(h)(3)(B), and is therefore taxable under § 367(d). Some taxpayers have argued that the workforce-in-place is a part of going concern value that transfers tax free to the foreign corporation. However, to the extent that workforce-in-place can be identified and valued as a distinct asset, workforce-in-place should not be viewed as part of foreign goodwill or going concern value.
The definition of foreign goodwill or going concern value requires a business operation conducted outside of the United States. Generally a business is conducted outside of the United States if its primary managerial and operational activities are conducted outside of the United States and substantially all of its assets are located outside of the United States. See Reg. § 1.367(a)-2T(b)(4) The § 936 corporation should be carefully examined to determine whether and to what extent it conducted a business operation outside of the United States. Where are its assets located and where are its managerial and operational activities conducted? For example, are the executive managerial activities conducted in the United States? Also relevant to this inquiry may be the nature and characteristics of the products sold to the United States versus products sold elsewhere, whether the § 936 corporation had separate business processes for products sold to the United States versus products sold elsewhere, whether the products sold to the US were regulated by US authorities while products sold elsewhere were regulated by foreign regulatory authorities, etc.[4]
It is important to recognize that section 367(d) is generally not affected by whether a particular intangible was developed in the United States or in a foreign country. Instead, section 367(d) is applicable when a domestic corporation transfers intangible property to a foreign corporation in a transaction under section 351 or section 361 (regardless of where that intangible was developed). For example, if a domestic corporation developed some know-how, and that know-how was transferred to a foreign corporation, section 367(d) would apply. It would be irrelevant for purposes of section 367(d) whether the know-how was developed in the United States or in a foreign country.
Planning and Examination Guidance:
The restructuring of international operations, in general, and of former Possession Corporations, in particular, has highlighted the significance of many issues, including the transfer and use of intangible property under section 367. The following discussion will provide examiners with an overview of the reporting requirements and operative provisions of section 367, and also provide examiners with some analytical tools for verifying taxpayer compliance with section 367.
If a taxpayer transfers property from a domestic corporation to a foreign corporation in a transaction involving section 367, the taxpayer is obligated to file a Form 926 and all related attachments. (Section 6038B). The Form 926 and attachments must contain the “estimated fair market value of the consideration received by the domestic corporation.”
In a typical restructuring, the Possession Corporation will receive stock as consideration for the assets transferred to the CFC pursuant to section 351 or section 361. In such a typical restructuring, the Possession Corporation will generally transfer all of its assets to the CFC in a single transaction. Under such circumstances, the stock received should be equal to the Business Enterprise Value of the Possession Corporation on the date of the transfer because all of the assets were transferred and the estimated fair market value of all of the assets should be equal to the Business Enterprise Value of the Possession Corporation on the date of the transfer.[5] Consequently, in order to meet its obligation to report the “estimated fair market value of the consideration received by a domestic corporation,” a Possession Corporation that transferred all of its assets pursuant to section 351 or section 361 will be obligated to report on the Form 926 and attachments the “Business Enterprise Value” of the Possession Corporation on the date of transfer. [6]
It is important to obtain the Business Enterprise Value from the taxpayer because that number will provide examiners and their experts with another means of analyzing the reasonableness of the taxpayer’s transfer pricing result. In addition, the Business Enterprise Value will help examiners identify the value of assets that the taxpayer is claiming are exempt from taxation under sections 367(d) and 367(a). Moreover, the Business Enterprise Value will provide the examination team with valuable information that is helpful in determining whether the taxpayer properly qualifies for the exceptions in sections 367(d) and (a).
If a taxpayer fails to provide the requisite information required on the Form 926, the taxpayer could be liable for penalties, including 10% of the fair market value of the property at the time of the transfer. (Section 6038B(c)). If a taxpayer can show that its actions did not constitute intentional disregard, the taxpayer will be liable for no more than $100,000 in penalties under section 6038A. A taxpayer can avoid penalties through a showing of reasonable cause.
In addition, if a taxpayer fails to provide the requisite information related to the transfer required on the Form 926, the statute of limitations for assessment of tax shall not expire until three years after the taxpayer has provided the IRS with such information. (Section 6501(c)(8)).
Issue Identification:
Steps to Determine if Potential Issues Exist:
-
In a Situation where the Possession Corporation Transferred All of Its Assets in a Single Transaction to the CFC -- Examine the Form 926 to Ensure that Taxpayer Properly Reported the Business Enterprise Value
- Instead of reporting the Business Enterprise Value, taxpayers often only report the total “book value” of their tangible assets.If a taxpayer has only reported the total “book value,” the exam team should issue an IDR asking taxpayer to provide the fair market value of all assets transferred, including workforce-in-place, goodwill and going concern (i.e. the Business Enterprise Value).
- Instead of reporting the Business Enterprise Value, taxpayers often report an amount they contend constitutes the total fair market value of their tangible assets.In doing so, this amount is often inaccurate because it does not include intangible assets such as workforce-in-place, goodwill and going concern. Furthermore, the amount reported is often roughly equivalent to the total book value, rather than fair market value, of their assets.As in the previous step, the exam team should issue an IDR asking taxpayer to provide the total fair market value of all assets transferred, which includes both tangible and intangible assets, including workforce-in-place, goodwill and going concern (i.e. the Business Enterprise Value).
- If a taxpayer has reported the Business Enterprise Value, go to Step 3.
- In a Situation where a Possession Corporation Transferred All of Its Assets in a Series of Partial Transfers over Several Years --Examine the Individual Forms 926 for Each Year
- Pursuant to sections 351 or 361, Taxpayer will receive stock for each partial transfer of assets in each year.
- Taxpayer has an obligation to report on a Form 926 the estimated fair market value of the stock received for each transfer for each year.The estimated fair market value of the stock received will be equal to the fair market value of the assets transferred.
- The sum total of estimated fair market value of each of the transfers of assets transferred should be approximately equal to the Business Enterprise Value of the Possession Corporation.
- Exam Teams should review the issues highlighted in Step 1 to ensure that the same issues do not arise in this Step 2.
-
Determination by IRS Economist or Outside Economist of the Business Enterpise Value
-
Retain either an IRS Economist or an Outside Economist.Ask the economist to perform an independent analysis of Business Enterprise Value of the Possession Corporation on the date of the transfer (or the date of the initial transfer in a series of partial transfers) of assets.
-
There are different methods of determining the Business Enterprise Value, such as an analysis of comparable market transactions, replacement cost or discounted cash flows.The economist should explore all of these alternatives in attempting to determine the Business Enterprise Value.
-
In order to determine the Business Enterprise Value through a DCF analysis, the economist must first make projections of future cash flows.Second, the economist must utilize an appropriate discount rate to determine the present values of those cash flows.The net present value of the future cash flows from the CFC should be equal to the Business Enterprise Value of the Possession Corporation on the date of the transfer (or the date of the initial transfer in a series of partial transfers).Consequently, in order to apply a DCF analysis, the exam teams should:
- Ask taxpayer for any projections of income relating to the CFC at the time of the transfer of assets from the Possession Corporation to the CFC pursuant to section 351 or section 361.
- If taxpayer does not have any projections of income relating to the CFC at the time of the transfer of assets, or if those projections of income appear to be unreliable, consider using the results of the IRS transfer pricing analysis.[7]
- Ask taxpayer what discount rate it used in analyzing the projections of income relating to the CFC.
- Ask taxpayer to provide the discount rate used by the US Parent for other business projects on the date of the transfer of assets from the Possession Corporation to the CFC pursuant to section 351 or section 361.
- Ask taxpayer to provide the discount rate used by the Possession Corporation for other business projects on the date of the transfer of assets from the Possession Corporation to the CFC pursuant to section 351 or section 361.
- Ask either the IRS Economist or the Outside Economist what additional information would be helpful for determining the Business Enterprise Value of the Possession Corporation.
- As an alternative theory, the economist should also determine the Business Enterprise Value through a DCF analysis that relies on the taxpayer’s transfer pricing results.In many cases, the Service will view this alternative approach as inherently unreliable because the Service fundamentally disagrees with the taxpayer’s transfer pricing results.However, it is possible that Appeals or a Court could agree either partially or completely with the taxpayer’s transfer pricing results.Under such circumstances, the exam team should be prepared to present a determination of Business Enterprise Value using the taxpayer’s transfer pricing results.Such an analysis will highlight the collateral issues that inevitably arise under section 367 if a decision maker adopts the taxpayer’s transfer pricing results.
-
Comparison of the Business Enterprise Value as determined by Taxpayer to the Business Enterprise Value as determined by the IRS Economist or Outside Economist
-
If the amount of the Business Enterprise Value as determined by taxpayer(see Step 1 or 2 above) is the same as the amount of the Business Enterprise Value determined by the economist, or there is no material difference in the amounts, then move onto step 5.
- If there is a material difference between Business Enterprise Value of the Possession Corporation as determined by taxpayer (See Step 1 or 2 above) and the Business Enterprise Value as determined by the IRS Economist or Outside Economist, ask the IRS Economist or the Outside Economist to identify any assets that may explain such difference (such as workforce-in-place, goodwill and going concern).
- If there is a material difference between Business Enterprise Value of the Possession Corporation as determined by taxpayer (See Step 1 or 2 above) and the Business Enterprise Value as determined by the IRS Economist or Outside Economist, ask taxpayer to explain how its transfer pricing results are consistent with such an inadequate transfer of value.Examine the Form 926 to ensure that taxpayer correctly reported the different categories of assets required to be disclosed.
-
Did taxpayer list any intangible assets, as defined in section 936(h)(3)(B), on their Form 926?
- Ask whether taxpayer transferred workforce-in-place, goodwill and going concern.
- Ask whether taxpayer transferred any “foreign goodwill or going concern value” as defined in section 1.367(a)-5T(iii).
- Did taxpayer list any assets subject to the exception in section 367(a)(3) for property used in the active conduct of a trade or business.If so, ask taxpayer to provide an explanation regarding how such assets qualify for the exception in section 367(a)(3).
This Directive is designed to help examiners identify and analyze the 367 issues that arise in the context of restructurings of 936 corporations. If examiners have additional questions about the issues discussed in this Directive or other related issues, they should contact:
Sec.482 Technical Advisor Matt Hartman (610) 320-5144 x125
Int’l Technical Advisor Jim Guidone (973) 569-4840
LMSB Field Counsel Michael Calabrese (414) 231-2811
LMSB Field Counsel Naseem Khan (312)368-8662
cc: Commissioner, LMSB
Deputy Commissioner, LMSB
Deputy Commissioner, International
Division Counsel, LMSB
Commissioner, SBSE
Chief, Appeals
Director, Performance, Quality and Audit Assistance
[1] While Exit Strategies #1 included an extensive discussion of the section 482 issues that arise out of the restructuring of section 936 corporations, this directive is focused on section 367 issues and will only address section 482 issues to the extent necessary to discuss those section 367 issues.
[2] For a more detailed discussion of this information relating to section 936 and the restructuring of section 936 corporations, please refer to the sections entitled “Background” and “Restructuring” in Exit Strategies #1.
[3] Section 367(a) applies in general to transfers of tangible assets, while section 367(d) applies to transfers of intangible assets.
[4] A number of complex issues arise in the analysis of a taxpayer’s claimed transfer of foreign goodwill or going concern value. A full discussion of such issues exceeds the scope of this Directive. Consequently, for further information regarding foreign goodwill or going concern value, please contact LMSB Field Counsel Michael Calabrese or Naseem Khan or IRS Technical Advisors Matt Hartman or Jim Guidone.
[5] It is important to recognize that the Business Enterprise Value of the Possession Corporation will include items such as workforce-in-place, goodwill and going concern.
[6] This Industry Directive primarily addresses situations where the Possession Corporation transferred all of its assets to a newly formed CFC in a single transaction. This analysis becomes more complicated if the Possession Corporation did not transfer all of its assets in a single transaction, but rather transferred its assets to the CFC in a series of partial transfers over several years. Under such circumstances, it may be difficult to compare the “Business Enterprise Value” of the Possession Corporation on the date of the transfer to the total fair market value of the assets transferred, since all of the assets were not transferred on a single day, but rather were transferred in a series of partial transfers over several years. Although the Business Enterprise Value may not match up exactly with the total fair market value of all the assets transferred, it will nonetheless provide a useful benchmark for measuring the reasonableness of the taxpayer’s valuation of each transfer, by comparing the Business Enterprise Value to the total valuation of all of the individual transfers of assets over several years.
[7] In a situation where the Possession Corporation transferred all of its assets to the CFC in a single transaction, the CFC’s transfer pricing results should generally be the same as the projections of income, unless there have been unexpected events that occurred after the transfer of assets. Absent such unexpected events, any significant deviation between projected income and actual income would be subject to a commensurate-with-income adjustment under either section 367(d)(2)(A) or section 482. In a situation where the Possession Corporation transferred all of its assets to the CFC in a series of transactions over several years, the economist may need to make other adjustments determine projected results.
|