Just like his last budget, President Obama’s FY 2012 contains provision on taxation of intangible transfers. As I describe last year, the proposals go to the issue of companies transferring their intellectual property to subsidiaries located in countries where the royalty income is tax at a low rate or not taxed at all. The parent company “sells” the IP to the subsidiary and then pays royalties to that subsidiary for the use of the IP. The key question is the fair market value of that transfer. US law requires that the transfer be valued at the same level as if it was an arms-length transaction between two independent entities. The parent would then pay US taxes on that income. There is concern that companies are low balling the value of the IP, “selling” it cheaply so as to minimize the amount of US taxes they have to pay on the income from those sales. The US loses in two ways, the tax on the income from the sale and the tax on the income from the royalties.
The specific proposals contained in the Treasury Departments’ General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals (aka The Green Book) are as follows:
TAX CURRENTLY EXCESS RETURNS ASSOCIATED WITH TRANSFERS OF INTANGIBLES OFFSHORE
Section 482 authorizes the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever “necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” The regulations under section 482 provide that the standard to be applied is that of unrelated persons dealing at arm’s length. In the case of transfers of intangible assets, section 482 further provides that the income with respect to the transaction must be commensurate with the income attributable to the transferred intangible assets.
In general, the subpart F rules (sections 951-964) require U.S. shareholders with a 10- percent or greater interest in a controlled foreign corporation (CFC) to include currently in income for U.S. tax purposes their pro rata share of certain income of the CFC (referred to as “subpart F income”), without regard to whether the income is actually distributed to the shareholders. A CFC generally is defined as any foreign corporation if U.S. persons own (directly, indirectly, or constructively) more than 50 percent of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons that own at least 10 percent of the corporation’s voting stock.
Subpart F income consists of foreign base company income, insurance income, and certain income relating to international boycotts and other proscribed activities. Foreign base company income consists of foreign personal holding company income (which includes passive income such as dividends, interest, rents, royalties, and annuities) and other categories of income from business operations, including foreign base company sales income, foreign base company services income, and foreign base company oil-related income.
A foreign tax credit is generally available for foreign income taxes paid by a CFC to the extent that the CFC’s income is taxed to a U.S. shareholder under subpart F, subject to the limitations set forth in section 904.
Reasons for Change
The potential tax savings from transactions between related parties, especially with regard to transfers of intangible assets to low-taxed affiliates, puts significant pressure on the enforcement and effective application of transfer pricing rules. There is evidence indicating that income shifting through transfers of intangibles to low-taxed affiliates has resulted in a significant erosion of the U.S. tax base. Expanding subpart F to include excess income from intangibles transferred to low-taxed affiliates will reduce the incentive for taxpayers to engage in these transactions.
The proposal would provide that if a U.S. person transfers (directly or indirectly) an intangible from the United States to a related CFC (a “covered intangible”), then certain excess income from transactions connected with or benefitting from the covered intangible would be treated as subpart F income if the income is subject to a low foreign effective tax rate. For this purpose, excess intangible income would be defined as the excess of gross income from transactions connected with or benefitting from such covered intangible over the costs (excluding interest and taxes) properly allocated and apportioned to this income increased by a percentage mark-up. For purposes of this proposal, the transfer of an intangible includes by sale, lease, license, or through any shared risk or development agreement (including any cost sharing arrangement)). This subpart F income will be a separate category of income for purposes of determining the taxpayer’s foreign tax credit limitation under section 904.
The proposal would be effective for transactions in taxable years beginning after December 31, 2011.
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LIMIT SHIFTING OF INCOME THROUGH INTANGIBLE PROPERTY TRANSFERS
Section 482 authorizes the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever “necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” Section 482 also provides that in the case of transfers of intangible assets, the income with respect to the transaction must be commensurate with the income attributable to the transferred intangible assets. Further, under section 367(d), if a U.S. person transfers intangible property (as defined in section 936(h)(3)(B)) to a foreign corporation in certain nonrecognition transactions, the U.S. person is treated as selling the intangible property for a series of payments contingent on the productivity, use, or disposition of the property that are commensurate with the transferee’s income from the property. The payments generally continue annually over the useful life of the property.
Reasons for Change
Controversy often arises concerning the value of intangible property transferred between related persons and the scope of the intangible property subject to sections 482 and 367(d). This lack of clarity may result in the inappropriate avoidance of U.S. tax and misuse of the rules applicable to transfers of intangible property to foreign persons.
The proposal would clarify the definition of intangible property for purposes of sections 367(d) and 482 to include workforce in place, goodwill and going concern value. The proposal also would clarify that where multiple intangible properties are transferred, the Commissioner may value the intangible properties on an aggregate basis where that achieves a more reliable result. In addition, the proposal would clarify that the Commissioner may value intangible property taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken.
The proposal would be effective for taxable years beginning after December 31, 2011.
The first proposal is a slight expansion of last year’s concerning treatment of subpart F income. The second proposal is exactly the same as last year (and similar to a proposal made as part of the FY 2010 budget) .
As I noted last year and two years ago, these provision are worth consideration and discussion. But they should be part of a larger discussion under the rubric of corporate tax reform. That larger discussion should include issues of a knowledge tax credit (human capital being one our most important intangible assets) and the “patent box” idea of lower rate on royalty revenues.
Our previous report, Intangible Asset Monetization: The Promise and the Reality, pointed out that taxation has not yet fully come to grips with the rise of importance of intangibles assets. We will see if this is the year that changes.