Section 367(d) of the Internal Revenue Code (the “Code”) provides rules for outbound transfers of intangible property (e.g., intellectual property) by a U.S. person (a “U.S. transferor”) to a foreign corporation. Under these rules, when a U.S. transferor transfers intangible property to a foreign corporation in an otherwise tax-free exchange under Sections[1] 351 or 361, the U.S. transferor is treated as having sold the intangible property in exchange for annual royalty payments (an “annual inclusion”) over the useful life of the intangible property (or a lump sum payment in the case of a disposition of the intangible property following the initial outbound transfer). The U.S. transferor treats the annual inclusion and lump sum as ordinary income and royalties for purposes of determining source and the foreign tax credit limitation category. Final regulations under Section 367(d) were published on December 16, 2016 (the “367 Regulations”).

On May 2, 2023, the Internal Revenue Service (“IRS”) and Department of the Treasury (“Treasury”) released a new set of proposed regulations (the “Proposed Regulations”), which, in certain cases, would terminate the continued application of certain provisions of the 367 Regulations arising from a previous transfer of intangible property to a foreign corporation when the intangible property is transferred to certain U.S. persons (such transfer of the intangible property back onshore is referred to below as a “repatriation” of such property).

Background and Operation of Section 367(d) Prior to Release of Proposed Regulations:

Congress enacted Section 367(d) to address its concern that U.S. companies would reduce their taxable income by taking deductions in connection with the development of intangible property and, prior to profitability, transferring the intangible property to a foreign corporation to ensure deferral of U.S. tax on the future profits generated by the intangible property. Section 367(d) is intended to prevent U.S. corporations from obtaining the benefits of certain non-recognition provisions of the Code, specifically Sections 351 (contributions to a controlled corporation) and 361 (corporate reorganizations),  upon the transfer of valuable intangibles offshore. Section 367(d)(1) provides that, except as provided in regulations, if a U.S. transferor transfers any intangible property to a foreign corporation (the “transferee foreign corporation”) in an exchange described in Sections 351 or 361, the U.S. taxpayer is treated as having sold the intangible property in exchange for annual, contingent payments (i.e., the annual inclusion) or, in the case of certain dispositions of the intangible property after the initial transfer, a payment reflecting the value at the time of that disposition (i.e., the lump sum). The deemed payments reflect the productivity or use of the intangible property by the foreign corporation and last through the intangible property’s useful life. For this purpose, the useful life is the entire period during which exploitation of the intangible property is reasonably anticipated to affect the determination of taxable income, as of the time of transfer.[2]

The 367 Regulations provide rules addressing a subsequent transfer of the intangible property; the tax consequences of such transfer depend on whether the transferee is related or unrelated (within the meaning of Sections 267 and 707, with some modifications) to the U.S. transferor. If the new transferee is unrelated, the U.S. transferor is required to recognize gain (but not loss) equal to the fair market value of the intangible property (determined as of the date of the subsequent disposition), less the U.S. transferor’s basis in the intangible property (determined as of the date of the initial transfer). If the new transferee is related, the same annual inclusion payment method applicable to the initial transfer will continue to apply, with the new transferee substituting as the initial foreign transferee corporation, even if the new transferee is a U.S. person. Thus, subsequent transfers of the intangible property to related U.S. persons potentially result in a double inclusion of income. Treasury and the IRS believe that continuing to apply section 367(d) in such cases would give rise to excessive U.S. taxation and disincentivize taxpayers from repatriating that property. Accordingly, the Proposed Regulations intend to alleviate some of these disincentives, as discussed below.

Explanation of the Proposed Regulations:

General Repatriation Consequences. The Proposed Regulations generally terminate the application of Section 367(d) to a prior transfer of intangible property if the transferee foreign corporation repatriates the intangible property to a “qualified domestic person” and certain reporting requirements are satisfied. If the repatriation and reporting requirements are satisfied, the Proposed Regulations require the U.S. transferor to include in gross income a partial annual inclusion attributable to the part of its taxable year that the transferee foreign corporation held the intangible property, after which the intangible property is no longer subject to section 367(d) (thus, the annual inclusion stream terminates).

Weil Observation: Terminating the continued application of Section 367(d) upon a repatriation to an initial U.S. transferor or a qualified domestic person is consistent with the policy underlying Section 367(d), given such a transfer merely restores the circumstances that existed at the time of the original outbound transfer subject to Section 367(d) and prevents the double inclusion of income that potentially occurred under the 367 Regulations.

Definition of “Qualified Domestic Persons”. A “qualified domestic person” includes (i) the U.S. transferor that initially transferred the intangible property subject to section 367(d) that is repatriated or a U.S. person treated as the U.S. transferor’s successor, so long as the successor is subject to current tax in the U.S or (ii) a U.S. person that is an individual or a qualified corporation related to the U.S. transferor.

Weil Observation: The definition of qualified domestic person references Code sections typically used to determine whether parties are related under several provisions of the Code, with some adjustments intended to expand which parties are considered related. Interestingly, the IRS and Treasury did not choose to either (i) treat a domestic partnership as a qualified domestic person, even if, or to the extent that, such domestic partnership has partners that are qualified domestic persons or (ii) adopt rules similar to those regarding gain recognition agreements to ensure that, to the extent relief provided applies to a repatriation, that the corresponding amount of income from the intangible property would be subject to tax in the U.S. Although treating domestic partnerships that have qualified domestic persons as partners as qualified domestic persons would appear to be consistent with the concerns intended to be addressed by the Proposed Regulations, the IRS and Treasury noted the potential for avoidance of income given the flexibility of partnerships to allocate income or gain with respect to the repatriated intangible property to non-U.S. partners and the administrative and compliance burden the IRS would face in policing such situations.   

Gain Recognition Rule. The Proposed Regulations also require the U.S. transferor to recognize gain (which amount may be zero in certain cases) as a result of the repatriation. The manner in which the repatriation occurs will determine whether the U.S. transferor must recognize gain in connection with the repatriation transaction, with corresponding adjustments made by the transferee foreign corporation.

Specifically, the gain recognition rule focuses on whether the intangible property is transferred basis property (as defined in Section 7701(a)(43)) by reason of the repatriation, without regard to the application of Section 367(d) and the 367 Regulations. If the intangible property is transferred basis property, the amount of gain the U.S. transferor will recognize pursuant to the gain recognition rule is the amount of gain the transferee foreign corporation would recognize, if any, upon the repatriation under general subchapter C rules if its adjusted basis in the intangible property were equal to the U.S. transferor’s former adjusted basis in the property. For example, the U.S. transferor would not recognize gain in the case of a repatriation occurring by reason of a non-recognition transaction pursuant to which no gain or loss is recognized by the transferee foreign corporation. The gain recognition rule, in conjunction with the required adjustments, generally ensures that a qualified domestic person does not receive a tax-free increase to the adjusted basis in the repatriated intangible property.

If the intangible property is not transferred basis property by reason of the repatriation, however, the amount of gain a U.S. transferor will recognize pursuant to the gain recognition rule is the excess, if any, of the fair market value of the intangible property on the date of the repatriation over the U.S. transferor’s former adjusted basis in the property. For example, if the transferee foreign corporation repatriates the intangible property to the U.S. transferor in a distribution described in Section 311, the intangible property is not transferred basis property, and therefore the rule described in this paragraph applies to determine the amount of gain recognized by the U.S. transferor under the gain recognition rule.

Required Adjustments Related to Certain Gain Recognized. In order to prevent excessive E&P and gross income as to the transferee foreign corporation because of the gain recognition rule or the 367 Regulations, the Proposed Regulations provide certain adjustments to the transferee foreign corporation’s E&P and gross income that arise by reason of any gain the U.S. transferor recognizes under the gain recognition rule or 367 Regulations. Pursuant to these adjustments, the transferee foreign corporation reduces (but not below zero) the portion of its E&P and gross income arising from the transaction to take into account the gain recognized by the U.S. transferor. As provided currently under the 367 Regulations, any gain so recognized can be received by the U.S. transferor without further U.S. tax consequences pursuant to the account receivable mechanism provided in the 367 Regulations.

Required Adjustments Related to the Annual Inclusion. The 367 Regulations provide that the transferee foreign corporation may treat a deemed payment arising from U.S. transferor’s annual inclusion as an expense (whether or not paid) properly allocated and apportioned against gross income subject to subpart F, in accordance with the Treasury Regulations Sections 1.954-1(c) and 1.861-8. The Proposed Regulations clarify that the deemed payment is treated as an allowable deduction, which can be allocated and apportioned under Treasury Regulations Sections 1.882- 4(b)(1), 1.954-1(c), and 1.960-1(c) and (d) (as appropriate) potentially to any class (or classes) of gross income (as appropriate) rather than solely to gross income subject to subpart F in all circumstances.

Section 904(d) Foreign Branch Income Rule. Section 904 and the regulations promulgated thereunder (the “Section 904 regulations”) provide, in relevant part, that the principles of Section 367(d) apply for determining gross income that is attributable to a foreign branch that must be adjusted under the Section 904 regulations. For reference, Section 904 provides for the application of separate foreign tax credit limitations to certain categories of income under Section 904(d). One of those categories is the separate category for foreign branch income under Section 904(d)(1)(B) (i.e., gross income of a U.S. person (other than a pass-through entity) that is attributable to foreign branches held directly or indirectly through disregarded entities by the U.S. person). In general, Treasury Regulations Section 1.904-4(f)(2)(vi)(A) adjusts the attribution of gross income when disregarded payments are made between a foreign branch and a foreign branch owner, or between foreign branches. Disregarded remittances or contributions, however, do not result in the reattribution of gross income. Accordingly, when a disregarded transaction with a foreign branch may be structured as either a remittance or contribution, on the one hand, or as a sale, exchange, or license, on the other hand, the amount of gross income attributed to a foreign branch could be manipulated. This concern is heightened when the property in question is highly mobile and highly valuable, as is generally true of intangible property (and less frequently true of tangible property).

If there are multiple transfers of an item of intangible property over time, each transfer must be separately evaluated and could result in differing amounts of deemed annual payments depending on any interim changes in the value of the intangible property between successive transfers. Accordingly, the Proposed Regulations provide that each successive transfer to which the Section 904 regulations apply should be considered independently from any other transfers. Therefore, the subsequent transfer rules in the regulations under Section 367(d), including the rule for repatriations provided in these Proposed Regulations, do not apply in the context of determining gross income attributable to the foreign branch income category and each successive transfer is separately subject to the provisions of Treasury Regulations Section 1.904-(f)(2)(vi)(D)(1) and will not terminate or otherwise impact the application of Treasury Regulations Section 1.904-(f)(2)(vi)(D)(1) to a prior transfer described in that paragraph.

Weil Observation: The IRS and Treasury appear to acknowledge the differing scopes of Sections 367(d) and 904 and note that the consequences of a subsequent transfer for purposes of determining a U.S. transferor’s inclusion under Section 367(d) does not necessarily inform the appropriate treatment for purposes of the Section 904(d) branch income rules. For purposes of the adjustment for disregarded payments, the Section 904 regulations provide that foreign branch income must be adjusted for transfers of Section 367(d)(4) intangible property between a foreign branch and its owner. For example, according to the Section 904 regulations, if a foreign branch owner transfers property described in Section 367(d)(4) to a foreign branch, the principles of Section 367(d) are applied by treating the foreign branch as a separate foreign corporation to which the property is transferred in exchange for stock of the corporation in a transaction described in Section 351. This rule is unusual in that it applies in both directions — outbound and inbound — regardless of whether the transfer is accompanied by an actual payment. The amount of the adjustment is made under the principles of Sections 367(d) and 482, which generally require an annual adjustment commensurate with the income generated by the property.

Other Modifications and Reporting. The Proposed Regulations eliminate Treasury Regulations Section 1.951A-2(c)(2)(ii), which provides that deductions taken into account in determining a CFC’s tested income and tested loss under Section 951A include the amount of a deemed payment under Section 367(d)(2)(A). This rule is no longer necessary because the Proposed Regulations provide that such deemed payments are treated as allowable deductions in accordance with, in relevant part, Treasury Regulations Section 1.951A-2(c)(3).

The Proposed Regulations also discuss the rules for determining the qualified domestic person’s adjusted basis in the repatriated intangible property, the consequences of having multiple U.S. transferors, and the special rule for related transactions. The Proposed Regulations make conforming changes to the reporting requirements in the 367 Regulations (which generally provided information reporting rules that apply with respect to transfers of property to foreign corporations).

[1] Unless otherwise indicated, all references in this article to “Section” are to the Code, and all references to “Treasury Regulations Section” are to the U.S. Treasury Department Regulations (i.e., the Treasury Regulations) promulgated under the Code.

[2] Note that outbound transfers of property other than intangible property are governed by Section 367(a) which causes gain recognition upon such transfer as if the property were sold at the time of the transfer at its fair market value. Section 367(d)(1) specifically provides that Section 367(a) does not apply to the outbound transfer of intangible property.