Firm Seeks Withdrawal of Transfer Pricing, Outbound Transfer Regs

August 7, 2017

The Honorable Steven T. Mnuchin
Secretary of the Treasury
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Re: Presidential Executive Order on Identifying and Reducing Tax Regulatory Burdens and Notice 2017-38

Dear Secretary Mnuchin:

Mayer Brown LLP appreciates the opportunity, in response to Notice 2017-38, to provide comment on whether certain regulations should be rescinded or modified and, in the latter case, what modifications are necessary to reduce burdens and complexity. Like other professional services firms, Mayer Brown represents many clients affected by these regulations. This comment letter focuses on the final regulations under Section 367 on the treatment of certain transfers of property to foreign corporations, issued by Treasury and the Service on December 16, 2016 (the “Final Regulations”).¹ The Final Regulations cross reference and are intended to be coordinated with temporary regulations under section 482 issued on September 14, 2015 (the “Temporary Regulations”).² While the Temporary Regulations were issued prior to 2016, they materially add to the impact of the Final Regulations on taxpayers and, therefore, should be reviewed together with the Final Regulations. It is no coincidence that the Temporary Regulations were issued on the same day that the Final Regulations were first proposed, September 14, 2015.

We recommend that both the Final Regulations and the Temporary Regulations be rescinded. Many commentators have expressed the view that the Final Regulations lack statutory authority and are not narrowly tailored to address the alleged valuation abuse.³ The Temporary Regulations’ requirement to treat “all value” as compensable has been frequently characterized as inconsistent with the overriding arm’s length standard.⁴ We share those views.

The Final Regulations and Temporary Regulations are premised in large part on the government successfully advancing its “all value” position in Amazon, Inc. v. Commissioner.⁵ On March 23, 2017, just months after issuing the Final Regulations, the Tax Court rejected the government’s theory that an arm’s length payment for the acquisition of rights in intangible property should be determined with reference to all the value, or the “enterprise value,” of the associated business. Taxpayers are facing uncertainty over how outbound transfers of property under section 367 should be valued under these two sets of regulations, as the fundamental tenets of valuation in these regulations are still being questioned in significant court cases. Treasury should consider withdrawing the Final Regulations and Temporary Regulations for the time being, and reconsider its position once the dust settles on the “all value” issue.

If the Final Regulations and Temporary Regulations are to be kept in place, we recommend several modifications. First, the Final Regulations should carve out exceptions for fact patterns that do not have significant potential for valuation abuse. One obvious fact pattern is where an active trade or business has been operated in branch form in a foreign jurisdiction for a period of years and a decision is made to convert the branch into corporate form. While a stated justification of the rules has been the inability of Treasury and the Service to write more narrow regulations that would forestall abuse, the case of a longstanding branch converted into corporate form provides a straightforward situation where a more narrow regulation could be promulgated without failing to address purported abuses.

Second, the Final Regulations and Temporary Regulations should clarify that, in the case of outbound transfers of a target company’s intangible property to a foreign jurisdiction following a buyer’s acquisition of a controlling interest in target stock, the requirement to account for “all value” applies with respect to the transferred property as distinct from the acquired target stock, Specifically, together these regulations should acknowledge that the price paid for target stock could exceed the fair market value of target’s assets due to either a control premium or another type of acquisition premium. Further, they should permit taxpayers to prove the existence and amount of these premiums in order to reduce the “base case” valuation of the target’s underlying assets before such valuation is used to determine an arm’s length payment for the transferred properties. Again, this is a case where a more narrow rule could be written without failing to address purported abuses.

Finally, the modifications we are recommending should apply retroactively at the taxpayer’s election to transfers on or after September 14, 2015, which is the effective date for both the Final Regulations and the Temporary Regulations.

Final Regulations Contradict Congressional Intent and are Not Tailored to Address Alleged Abuse

The Final Regulations purport to tax the full value of outbound transfers of property in certain nonrecognition transactions, except for value attributable to tangible assets (other than inventory) and certain financial assets. This is accomplished by, first, restricting the scope of “eligible property” that can be transferred under the “active trade or business” exception of section 367(a)(2); second, eliminating the regulatory exception for “foreign goodwill and going concern value” that has been in place since 1986; and third, eliminating the 20-year maximum period for useful life. The regulations do not resolve the longstanding debate over whether foreign goodwill or going concern value, or workforce in place, is a “similar item” under section 936(h)(3)(B) and hence covered by section 367(d). Under this new regime, all intangible property transferred outbound is taxable, whether the property is clearly section 367(d) property, foreign goodwill or going concern value, or some other intangible property considered to be outside of section 367(d).⁶ The Final Regulations offer no guidance on how to value intangible property, other than making reference to section 482 and the regulations thereunder, which would include the new Temporary Regulations.

Treasury and the Service have pursued an aggressive interpretation of the legislative history of section 367. The statute divides the world into active trade or business property under section 367(a) and intangible property described in sections 367(d) and 936(h)(3)(B), but does not otherwise address the treatment of foreign goodwill or going concern value or any other intangible property not explicitly listed in section 936(h)(3)(B) or otherwise considered “similar” to the 27 items on that list. Thus, the legislative history is of paramount importance in deciding the treatment of intangible property that falls in the gap.⁷ Despite seven different statements in the legislative history supporting a taxpayer’s ability to transfer foreign goodwill and going concern value on a nontaxable basis,⁸ Treasury and the Service have latched onto one particular statement to the effect that Congress “does not anticipate” that transfers of these assets from a foreign branch to a newly organized foreign corporation “will result in abuse of the U.S. tax system.”⁹ Based almost solely on the view that Congress would not have permitted nontaxable transfers of foreign goodwill and going concern value had it been aware of the abusive practices of taxpayers to overvalue foreign goodwill and undervalue section 936(d) property, Treasury and the Service have reversed a thirty-year exemption of these assets from taxation.¹⁰ This is quite remarkable, in the absence of any legislative change to the relevant section 367 rules.

Prevention of Abuse is Seemingly a Straw Man for Treasury's Legislative Agenda

Even if the prevention of valuation abuse were sufficient justification for a change to the section 367 regulations, the Final Regulations offer an underwhelming explanation for why the taxation of all intangible property including foreign goodwill is the most appropriate way for addressing that abuse. Basically, the government is saying it is too administratively difficult to provide guidance for how taxpayers can properly value foreign goodwill and going concern value, without also ensuring “that section 367 applies with respect to the full value of all section 936 intangibles.”¹¹ Thus, the government claimed it had no choice but to tax all intangible property without regard to whether such property is or is not governed by section 367(d), The government’s approach is the proverbial “throwing the baby out with the bathwater.”

The government’s justification of an anti-taxpayer position in order to avoid an “administratively difficult” valuation is not well perceived by the courts. For example, in Nestle Holdings, Inc. v. Commissioner,¹² the IRS argued that a taxpayer’s income from the receipt of preferred stock should be based on redemption price rather than fair market value because of the administrative and judicial burdens from having to value the stock. The Tax Court advised the IRS that its argument is “almost too disingenuous to require comment” and that “the concept of fair market value has always been part of the warp and woof of our income, estate, and gift tax laws, and concomitantly the necessity of determining the fair market values of numerous assets for equally numerous purposes has always been a vital and unavoidable function of the tax administrative and judicial process.”

Every suggestion from commentators for a special exception was shot down on the grounds that anything other than a blunt instrument would not address the valuation uncertainty as well as the tax abuse that could occur when value is allocated between foreign goodwill and the listed section 367(d) intangibles (e.g., patents, designs, copyrights, trademarks, trade names, franchises, contracts, systems, programs and customer lists).¹³ As a result, the Final Regulations apply indiscriminately to all outbound transfers of property in a section 367 nonrecognition transaction. No distinction is made between transfers that move property to a foreign jurisdiction for the first time and the incorporation of a foreign branch that has operated exclusively in the foreign jurisdiction for many years. No distinction is made between outbound transfers driven solely by tax planning objectives and the incorporation of a branch that is forced on a taxpayer by regulators. The Final Regulations even apply when the taxpayer is able to prove that the outbound transfers consist exclusively of an active business and foreign goodwill with no section 367(d) intangibles of any significance.

One can certainly question the government’s claim that valuation abuse led to this extraordinarily harsh reversal of a longstanding regulatory position. Only one particular case of an alleged abuse is known to the tax community, and that is the case involving First Data Corporation, for which a technical advice memorandum (TAM 200907024 ) was issued and a Tax Court petition was filed.¹⁴ IRS apparently claimed that taxpayer valued 97% of the transferred intangible property as being attributable to foreign goodwill, with only 3% being attributable to section 367(d) property (i.e., contracts with foreign agents to transact business with foreign customers). Otherwise there is no empirical data or other publicly known information about the abusive taxpayer cases referenced by Treasury and the Service in the preamble to the Final Regulations. Essentially the government is justifying its new position by saying “trust us, it’s really bad out there.”

This justification based on valuation abuse begs the broader question of why the section 367 area is so special that it needs an overarching (and overreaching) rule in order to avoid an administratively difficult review of a taxpayer’s valuation. The tax area is replete with situations where significant tax liability may rest entirely on whether a taxpayer’s valuation of a business is respected. The term “fair market value” appears “in about 200 sections of the Internal Revenue Code . . . and in about 900 sections of the supporting Treasury regulations.”¹⁵ These other areas of the tax law are policed through the desire of taxpayers to reach a valuation that can be properly defended and the professional and ethical standards of the appraisal industry. What is it about the section 367 area — an area populated mostly by multinational corporations with public financial statements, standards for keeping reserves, and financial means to hire competent appraisers, among other things — that has engendered such mistrust within the Service?

The more logical explanation is that the section 367 area is part of a three-legged stool along with taxable sales and licenses under the section 1.482-4 regulations and cost sharing under the section 1.482-7 regulations. Treasury and IRS have been pursing their “all value” position in the general section 482 area and the cost sharing area through a combination of regulatory changes (e.g., the Temporary Regulations) and litigation efforts. There is no doubt that the government has been bothered by the inconsistency between its “all value” efforts in section 482 and cost sharing, on the one hand, and the inability to treat foreign goodwill and going concern as taxable property in the section 367 area, on the other hand. Each of these areas, in the government’s view, is interchangeable; that is, the taxpayer has various choices for moving valuable intangible property offshore (e.g., taxable sale or license, cost sharing, or a nonrecognition transaction described in section 367) and there is no reason for the tax treatment to be different. However, recognizing the hurdles imposed by the section 367 statute and legislative history, the government chose to pursue legislative changes. When the legislative efforts repeatedly failed, Treasury chose to effectively implement by regulation what Congress chose not to do.

Final Regulations, Together with Temporary Regulations, Promote Service’s Failed Litigating Positions in Veritas and Amazon, and Therefore Should be Reconsidered

While the Final Regulations do not determine whether foreign goodwill or going concern value or workforce in place are covered by section 367(d), they nevertheless cause transfers of those properties to be taxable under section 367(a) if section 367(d) does not apply, permit taxpayers to elect the application of section 367(d) to those properties in lieu of section 367(a), and reserve the right to challenge a taxpayer’s characterization of those properties under section 367(a). This is a fairly bold move by the government, considering that the Tax Court in Veritas¹⁶ held that, for cost sharing purposes under section 482, section 936(h)(3)(B)’s reference to “similar items” does not include foreign goodwill or going concern value or workforce in place. And section 482, like section 367(d), defines intangible assets by reference to section 936(h)(3)(B).¹⁷

Following the government’s loss in Veritas (which was not appealed by the IRS), the Obama Administration proposed in its fiscal budgets for 2010 through 2015 to amend section 936(h)(3)(B) to incorporate the Service’s litigating position on foreign goodwill or going concern value and workforce in place. This proposal also would permit the valuation of multiple properties in the aggregate and the consideration of realistic alternatives. After these legislative efforts failed. Treasury in effect adopted the Service’s litigating position in the Final Regulations and the Temporary Regulations.

The Final Regulations further provide that the useful life of intangible property “includes any direct or indirect use or transfer of the intangible property, including . . . use in the further development of the intangible property itself . . . and . . . in the development [and exploitation] of other intangible property.”¹⁸ This language is designed to capture future generations of a product that can be traced back to the original property, and is described as being consistent with the cost sharing provisions in Treas. Reg. § 1.482-7(g)(2)(ii)(A).¹⁹ The Final Regulations permit taxpayers to recognize royalty income over a 20-year period, but the income must still reflect the present value of amounts expected after the 20-year period if the useful life is expected to exceed 20 years.

The government’s perpetual life theory also was rejected in Veritas. The Service argued that the transfer of intangible property pursuant to a cost sharing agreement is “akin to a sale” of the business because the intangibles have a perpetual life due to subsequent generations of intangibles emanating from the original transfer. The Tax Court held instead that the intangible property had a finite life of only four years, notwithstanding its recognition that the property enabled future generations of the product to be developed. The above-quoted language from the Final Regulations is yet another attempt by the government to reverse Veritas by regulation.

The Temporary Regulations complement the Final Regulations by including several key features, in a further effort to overturn Veritas. First, the arm’s length compensation in a controlled transaction, regardless of the transaction’s form or character, must account for “all value” provided between the parties. Second, the aggregation principle previously in the section 482 regulations was expanded to apply when multiple Code provisions are involved (e.g., both section 367 and section 482). Third, in an apparent rejection of the residual method, the regulations require that once “all value” is determined on an aggregate basis, it must be allocated among the various transferred assets. Finally, the regulations’ increased reliance on the realistic alternative principle implies that the government plans to price controlled transaction based on an alternative transaction that was not selected, without regard to whether the transaction chosen has economic substance.

In the recent Amazon decision the Tax Court reinforced its holding in Veritas and raised to new heights its objections to the government’s “all value” position. Citing the similarities with Veritas, the court stated that “both assumed that the pre-existing intangibles . . . had a perpetual useful life,” both valued “into perpetuity the cash flows supposedly attributable to the preexisting intangibles,” and “both treated the transfer of pre-existing intangibles as economically equivalent to the sale of an entire business.” Just like in Veritas, the IRS “improperly included in the buy-in payment the value of ‘subsequently developed intangibles.'" By deeming the transferred properties to have a value equal to their “enterprise value” less the tangible assets, the IRS improperly included workforce in place, going concern value and goodwill in the value of the transferred intangibles. The Service’s use of the aggregation principle improperly aggregated pre-existing intangibles with both “subsequently developed intangibles” and “residual business assets.” Finally, the Service’s attempt to apply the realistic alternative principle was rejected, as it failed to show that taxpayer’s actual cost sharing structure lacked economic substance.

The government may take the view that neither Veritas nor Amazon affects its ability to apply the principles in the Temporary Regulations to section 367 transactions. Those cases, the government will likely say, were decided under old cost sharing regulations and that the new cost sharing regulations finalized in 2011 permit the “all value” arguments that were rejected in those cases. That is far from clear but, regardless, the arm’s length standard has not changed and continues to be the controlling principle in deciding transfer pricing disputes.²⁰

If the world had just ended with Veritas, there would be a significant issue of whether the Final Regulations, together with the Temporary Regulations, represent a valid application of the arm’s length standard. After all, the decision in Veritas was ultimately based on the arm’s length standard. With the recent decision in Amazon, however, the pressure on the validity of these two sets of regulations has compounded exponentially.

If Final Regulations and Temporary Regulations are Not Withdrawn, They Should be Modified and Clarified

The Final Regulations offer no guidance on when a valuation of intangible properties would be considered abusive. Apparently the government believes that since its sweeping new rules would tax all value other than tangible property and certain financial assets listed in the definition of eligible property, there will no longer be any need to allocate value between separate items of intangible property. But that is far from true. Each item of intangible property could have a separate useful life for purposes of calculating a royalty under section 367(d), necessitating separate valuations. Some items of intangible property such as foreign goodwill could be subject to section 367(a) if an election is not made to apply section 367(d), again necessitating a separate valuation of such property.

Because eligible property is not taxed under section 367(a), obviously there will be a need to allocate value between eligible property and noneligible property. If a traditional residual method were used, the tangible properties and identifiable intangible properties would first be valued, and the residual value would be allocated to goodwill and going concern value.²¹ Indeed, for many years the section 367 regulations defined goodwill as the residual value.²¹ However, the Final Regulations eliminated the definition of residual goodwill, which had been in place for 30 years, stating it was “no longer needed."²² residual method to guide the valuation, will taxpayers be able to allocate the “excess value” among eligible and noneligible properties alike? After all, goodwill and going concern value are intimately tied to the active trade or business assets. Will the Service assert that all the excess value must be attributable to the identified intangible properties? If so, on what basis?²³

Some commentators asked that regulations carve out an exception for the incorporation of a longstanding branch that conducts an active business operation. In this situation, there is a strong likelihood that significant goodwill resides in the branch, and such goodwill is foreign-sourced rather than domestically sourced. Regardless of any administrative concerns about abuse, taxpayers in those situation should be given the opportunity to prove the value of the foreign goodwill without facing a bright-line rule. Treasury and the IRS declined to make this exception because it would “not address the administrative difficulties” in determining how much value should be allocated to foreign goodwill as opposed to enumerated section 936 intangibles, nor would it address the taxpayer’s incentive to adopt “aggressive valuation positions.”

The government’s claim that separating identified intangibles from the residual goodwill is “unduly difficult to administer” is puzzling, given the Treasury and the Service’s longstanding policy of promoting the residual method of valuation. It has been prescribed for over 30 years in the section 338 and 1060 regulations for purchase price allocation purposes, and is supported by the Supreme Court in Newark Morning Ledger Co. v. United States.²⁴ For many years prior to the 1993 enactment of section 197, the government routinely argued for the residual valuation method in order to maximize the amount of non-amortizable goodwill. Just recently, in TAM 200907024, the IRS asserted that the residual method — as set forth in Treas. Reg. § 1.367(a)-lT(d)(5)(iii) and as interpreted in Newark Morning Ledger — permitted identifiable intangible assets to be carved out of residual goodwill and valued separately. The residual approach is used for accounting purposes to value intangible property and goodwill, and underlies the reporting of goodwill in publicly filed financial statements. It is an indication that a successful business enterprise can be valued in excess of the sum of its parts. And the recognition that the residual method is the best approach for valuing goodwill and going concern value outside the section 367 context renders untenable the claim that no narrower rules could ever be applied without abuse. In short, at the very least, an exception should be made for the incorporation of longstanding foreign branches.

Similarly, even if the government’s “all value” position is retained in the Final and/or Temporary Regulations as a general rule, taxpayers need clarification on how that position applies to a target company’s outbound transfer of properties following a buyer’s acquisition of a controlling interest in the target company’s stock. As we’ve seen in the cost sharing area, the Service prefers to use the acquisition price method to value intangible property when such property is made available to a cost sharing arrangement following a target stock acquisition. That is, the stock acquisition price serves as a starting point for valuing the target’s assets. However, those regulations recognize that the asset value must be reduced for the value of any asset that is not part of the “platform contribution.”

As in the cost sharing area, the Service may be tempted to attribute the stock acquisition price to the value of the target’s underlying assets. For this reason, the Final Regulations and/or Temporary Regulations should be modified to make clear that the “all value” directive refers to the value of the assets transferred in the section 367 transaction. Further, they should provide that the slock acquisition price cannot be used as a starting point for valuing the noneligible assets without making adjustments not only for eligible assets but also for value reflected in the stock price that is not reflected in the underlying asset value.

One prime example of where a stock acquisition price exceeds the underlying asset value is where a control premium has been paid. Adjusting the valuation of the target’s underlying assets for a control premium is consistent with Philip Morris, Inc. v. Commissioner,²⁵ in which the acquisition of a controlling interest in a corporation was considered a separate element of a purchase price, “over and above the value that is attributable to the corporation’s underlying assets.”²⁶ In Philip Morris a tobacco company acquired a beverage company in a hostile tender offer. To encourage shareholders to sell their shares, the taxpayer offered to pay a premium above the publicly traded market price. Because of former Code § 334, the purchase price was allocated to target’s assets for tax basis purposes. The determination of basis depended on whether the acquisition price exceeded the value of the underlying assets. The Tax Court held it did, stating that the “portion of the purchase price paid to induce a transfer of shareholder control cannot be considered a payment for a corporate asset. . . .²⁷ The Tax Court in Philip Morris emphasized the independent value of the positive features of owning a controlling interest in stock: “. . . the shareholder can unilaterally direct corporate action, select management, decide the amount of distribution, rearrange the capital structure, and decide whether to liquidate, merge or sell assels.”²⁸

The section 338 and 1060 regulations attribute the target company stock price to the value of the underlying assets, yet through their use of the residual approach the control premium in effect is housed within the goodwill and going concern value. But if goodwill and going concern value arc not going to be valued on the residual basis, it is illogical to assume that the purchase price of a company’s stock reflects nothing but the fair market value of its underlying assets. Elementary valuation principles demand that, if the residual method is to be abandoned, the stock acquisition price must be reduced to the extent it reflects value associated only with the stock acquisition before it can be used as a proxy for the value of the company’s underlying assets.

Control premiums typically will represent a large part of the purchase price. The amount of a control premium depends on how much incremental value can be created as a result of having the rights to appoint management, set management compensation, set policy and change the course of the business, among other things. That is, acquisition of control by itself does not lead to a premium, but rather it is the identified potential for increasing value which depends on the facts of each case. It is common to see control premiums range between 20% and 40%, but they can be significantly higher in individual cases.²⁹

Apart from a control premium, there may be an acquisition premium paid for the additional synergy value resulting from the investments or unique assets of buyer that will be contributed or otherwise made available to target going forward. Sometimes the additional investments or contributions will be fully factored into the valuation of target stock, using a discounted cash flow model. In that case the government may argue, as it did in Veritas and Amazon, that the current value of the transferred assets should reflect the projected value that will be generated from investments and contributions of buyer. However, in Amazon the Tax Court rejected the notion that a party acting at arm’s length would pay twice for that additional projected value, once when the outbound transfer is made and again when the investments are needed to generate that value. In other cases the additional investments or contributions are not fully factored into the discounted cash flow model as costs even though the projected revenues are fully counted. In that situation the ease for an adjustment to the asset value is even more clear, as the stock price has been inflated above the true present value of the net cash flows.

We commend Treasury for its efforts to alleviate the tax regulatory burdens on taxpayers. We would be pleased to discuss with appropriate personnel the issues addressed in this letter if that would be helpful. Please feel free to contact Gary Wilcox at (202) 263-3399, Thomas Kittle-Kamp at (312) 701-7028, or Joel Williamson at (312) 701-7229.

Sincerely,

MAYER BROWN LLP
Chicago, IL