Yesterday was Shrove Tuesday, also known to much of the world as Fat Tuesday or Mardi Gras. In Washington, it was Budget Day — when the President released his FY 2015 budget proposals. The release, of course, generated a torrent of analysis. (For general comments, see the Wall Street Journal, the New York Times, the Washington Post and these two positive pieces on the relevance of the budget in the New Republic and Politico).
Putting aside all the hype and punditry, I want to focus on one aspect of story for now (I will have more later). As part of budget process, the Treasury Department also releases its General Explanations of the Administration’s Revenue Proposals (aka the “Greenbook”) which looks at the tax side. Much will be said about the larger picture presented by these proposals to change the tax code. I will focus on a few provisions directly relating to intangibles.
As in previous years, the Administration once again proposes to tight up the regulations on the transfer of intangibles. This year’s proposal (below) is a modified version of last year’s proposal and the proposals from FY 2013, FY 2012 and FY 2011 and FY 2010.
As I’ve described before, 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 proposals go after a couple of issues with transfer pricing. The first proposal deals with imposing a tax on excess income from intangibles transferred to low-taxed affiliates. The second proposal goes to the enforcement powers of the IRS Commissioner under Section 482 to place his/her own value on a transfer whenever “necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” The proposal would allow the Commissioner to value the intangible on an aggregate basis. This appears to go after the well-know issue that portfolios on intangibles are more valuable than the individual items taken separately. The next issue is related. The proposal would expand the definition to include workforce in place, goodwill and going concern value. Those three intangibles are essentially “whole-enterprise” assets. They cannot be split off from the enterprise. As such, they are generally not transferred from entity to another as individual components like a patent or a trademark could be. Thus, the proposal allows the IRS to value the package rather than the parts. The proposal also goes after the issue of valuation by setting the standard as “taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative.”
The proposals also include a provision to simplify the treatment of intangibles by repealing certain anti-churning provisions, which was first proposed last year.
Whereas the previous proposals focus on the transfer of intangible assets, the new proposal seeks to deal with the income generated from sale of digital goods and services. It would included some of that income as part of a “foreign base company income” and therefore subject to certain taxation.
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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 asset 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. In the case of an effective tax rate of 10 percent or less, the proposal would treat all excess income as subpart F income, and would then phase out ratably for effective tax rates of 10 to 15 percent. 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, 2014.
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LIMIT SHIFTING OF INCOME THROUGH INTANGIBLE PROPERTY TRANSFERS
The Secretary may 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). In the case of transfers of intangible property (as defined in section 936(h)(3)(B)), section 482 also provides that the income with respect to the transaction must be commensurate with the income attributable to the transferred intangible property. 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 a transaction that would otherwise be tax-free under section 351 or section 361, the U.S. person is treated as (i) having sold such property in exchange for payments which are contingent upon the productivity, use, or disposition of the property, and (ii) receiving amounts which reasonably reflect the amounts which would have been received annually in the form of such payments over the useful life of the property, or, in the case of a disposition following such transfer, at the time of the disposition. The amounts taken into account shall be commensurate with the income attributable to the intangible. Finally, under the regulations issued pursuant to section 367(e)(2), if a U.S. subsidiary corporation transfers intangible property (as defined in section 936(h)(3)(B)) to a foreign parent corporation in an otherwise tax-free liquidation described in section 332, the U.S. subsidiary must recognize gain upon the distribution of such 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. 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 provide that the definition of intangible property under section 936(h)(3)(B) (and therefore for purposes of sections 367 and 482) also includes workforce in place, goodwill, and going concern value, and any other item owned or controlled by a taxpayer that is not a tangible or financial asset and that has substantial value independent of the services of any individual. The proposal also would clarify that where multiple intangible properties are transferred, or where intangible property is transferred with other property or services, the Commissioner may value the properties or services 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, 2014. No inference is intended regarding the scope of intangible property included in section 936(h)(3)(B) under current law.
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REPEAL ANTI-CHURNING RULES OF SECTION 197 OF THE INTERNAL REVENUE CODE
In 1993, Congress enacted section 197 of the Internal Revenue Code to allow the amortization of
certain intangibles (such as goodwill and going concern value). Prior to the enactment of section
197, such intangibles were not amortizable. To “prevent taxpayers from converting existing
goodwill, going concern value, or any other section 197 intangible for which a depreciation or
amortization deduction would not have been allowable under [prior] law into amortizable
property,” Congress enacted section 197(f)(9), which excludes an intangible from the definition
of amortizable section 197 intangible if (1) the intangible was held or used at any time on or after
July 25, 1991, and on or before August 10, 1993 (the “transition period”), by the taxpayer or
related person; (2) the taxpayer acquired the intangible from a person who held it at any time
during the transition period, and, as part of the transaction, the user of the intangible does not
change; or (3) the taxpayer grants the right to use the intangible to a person (or a person related
to that person) who held or used the intangible at any time during the transition period.
Reasons for Change
The rules under section 197(f)(9) are complex. Because it has been almost 20 years since the
enactment of section 197, most of the intangibles that exist today did not exist during the
transition period and, thus, would not be subject to section 197(f)(9). Even though the number of
intangibles subject to section 197(f)(9) may be minor, taxpayers must nevertheless engage in due
diligence to determine whether such intangibles exist and then navigate the complex rules of
section 197(f)(9). Accordingly, the complexity and administrative burden associated with
section 197(f)(9) outweighs the current need for the provision.
The proposal would repeal section 197(f)(9) effective for acquisitions after December 31, 2013.
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CREATE A NEW CATEGORY OF SUBPART F INCOME FOR TRANSACTIONS INVOLVING DIGITAL GOODS OR SERVICES
Internal Revenue Code (Code) sections 952 and 954 describe certain categories of income that, when earned by a controlled foreign corporation (CFC), are currently included in the income of United States shareholders of that CFC as subpart F income under Code section 951. These categories include “foreign base company income”, which includes foreign personal holding company income, foreign base company sales income, and foreign base company services income. Foreign personal holding company income generally includes rents and royalties other than those derived in the active conduct of a trade or business and received from a person other than a related person. Foreign base company sales income generally includes income earned in connection with a purchase and subsequent sale of personal property where such property is purchased from (or on behalf of), or sold to (or on behalf of), a related person, provided the property is manufactured outside of the CFC’s country of organization and sold for use or consumption outside that country. Foreign base company services income generally includes income earned in connection with the performance of certain services performed outside of the CFC’s country of organization for or on behalf of a related person. All these categories of subpart F income are intended to ensure that tax is not deferred on income that is not generated by an active trade or business of the CFC.
Digital transactions involving copyrighted articles can take the form of leases, sales, or services. For example, a transaction involving a transfer of a computer program (i.e., a copyrighted article) could be characterized as a sale or lease of the computer program, depending on the facts and circumstances concerning the benefits and burdens of ownership with respect to the computer program. A computer program hosted on a server also might be used in a transaction characterized as the provision of a service to a user who accesses the server from a remote location.
Reasons for Change
The existing categories of subpart F income do not adequately address mobile income earned from providing digital goods and services. By choosing different forms for substantially similar transactions involving digital goods and services (leases, sales, or services), taxpayers may be able to avoid the application of the existing subpart F rules. In this regard, the subpart F rules, which are generally intended to require current U.S. taxation of passive and highly mobile income, have not kept pace with advances in technology. This shortcoming enables CFCs to shift income related to digital goods and services to low-tax jurisdictions, in many cases eroding the U.S. tax base. For example, a CFC may be able to conduct business with remotely-located customers through the “cloud” using intangible property acquired from a related party and without conducting any substantial business activities of its own.
The proposal would create a new category of subpart F income, foreign base company digital income, which generally would include income of a CFC from the lease or sale of a digital copyrighted article or from the provision of a digital service, in cases where the CFC uses intangible property developed by a related party (including property developed pursuant to a cost sharing arrangement) to produce the income and the CFC does not, through its own employees, make a substantial contribution to the development of the property or services that give rise to the income. An exception would apply where the CFC earns income directly from customers located in the CFC’s country of incorporation that use or consume the digital copyrighted article or digital service in such country.
The proposal would be effective for taxable years beginning after December 31, 2014.
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Our previous report, Intangible Asset Monetization: The Promise and the Reality, pointed out that taxation is an important policy tool that has not yet fully come to grips with the rise of importance of intangibles assets. For example, we have long advocated the expansion of the R&D tax credit into a knowledge tax credit by incorporating tax incentives for investments human capital as well as research. As part of a review of the intangibles and taxation, we suggest that it might be time to “explore lowering the tax rate on intangible asset royalties, in conjunction with stricter regulations on international transfer-pricing mechanisms and cost-sharing arrangements and on passive investment companies.” The report goes on to say:
Providing a more direct tax incentive to the licensing of intangibles by lowering the rate on intangible asset royalties, such as to the capital gains rate, is a more controversial proposal. This lower rate could be crafted to apply only to royalties for new licenses for a limited time, such as a sliding scale for three years. In crafting such an incentive, safeguards would need to be established to prevent the incentive from being used for simply transferring existing licenses to SPEs [special purpose entities] and to ensure that the incentive went to new licensing activities only.
As I’ve noted before, we have yet to have that discussion in any of the previous years when the Administration made its proposals. Maybe this year will be different. At a minimum, I suspect that the new proposal on taxation of digital goods and services will attract attention.