Transfer of Intangibles to Partnership May Qualify for Nonrecognition

LEGEND:

[3] On Date 1, A and D entered into a "Joint Venture Agreement," which became effective on Date 2. The Joint Venture Agreement will be hereinafter referred to as "the Agreement." D is an entity organized under the laws of country E and is classified as a corporation for U.S. tax purposes. Pursuant to the Agreement, A and D agreed to produce and market product F in Europe and agreed to form G, a business entity organized under the laws of country E and classified as a partnership for U.S. tax purposes. D contributed plant, equipment, spare parts, and customer lists in exchange for a 50 percent interest in G. A caused C to contribute certain interests in the B process technology in exchange for A's 50 percent interest in G. ¹ The interest in the B process technology consisted of: (1) the non-exclusive right to use and have access to the B process technology under terms and conditions of a separate agreement between C and G; and (2) the exclusive right to have access to and to use a related technology in a specifically delineated area. G did not have the right to sublicense the technology in either instance.

[4] On or about Date 3, C filed with the Service a Form 926, Return of a U.S. Transferor of Property to a Foreign Corporation, Foreign Estate or Trust, or Foreign Partnership. In Part II, Transfers Exempt from Excise Tax, C indicated that: (1) it was not making an election under section 1057; (2) the transfer was not a transfer described in section 367; and (3) it was electing to apply principles similar to the principles in section 367.

[5] In a statement attached to the Form 926, C stated that:

[7] In Article IV, Section (c)(vi) of the Tax Matters Agreement, which was incorporated into the Agreement via Article VI, Section 6.5, and attached thereto as Exhibit A, the parties agreed that A was entitled to a special allocation of 100 percent of the deemed royalty deductions available to G resulting from application of section 367(d). As a result of this allocation, any deemed royalty income reported by A will be entirely offset by a corresponding royalty deduction. ² The partnership did not issue a Schedule K-1 to A for either Year 1 or Year 2.

[8] The statute of limitations for Year 1 expires on Date 4, and we understand that Examination is preparing a statutory notice of deficiency. The questions you raise relate to whether adjustments will be proposed with respect to the transaction.

      SECTION 351 TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR

[10] Section 1491 imposes a 35 percent excise tax on any unrecognized gain associated with a transfer of property to a foreign partnership. A transferor of property to a foreign partnership may avoid taxation under section 1491 by electing to apply the taxation principles contained in section 367 to the outbound property transfer. See I.R.C. section 1492(2)(B). In such case, the transaction must constitute a "transfer of property" for purposes of section 1491. In the case of a transfer of "property" to a foreign partnership, the "property" principles found in Subchapter K of the Code (sections 701-761) are relevant in determining whether "property" has been "transferred" for purposes of section 1491.

[11] Contributions of property to a partnership in exchange for a partnership interest therein are governed specifically by section 721. There are no precise, consistent definitions for the terms "contribution," "property," and "exchange" included in section 721(a). Section 351 is analogous to section 721 because section 351 addresses property transfers to corporations in exchange for stock in such corporations. Section 351 is not, however, the Subchapter C mirror image of section 721 because section 351 only governs transfers by "controlling" shareholders. See I.R.C. sections 351(a), (c), and 368(c). Exchanges involving "noncontrolling" shareholders are governed by sections 118 and 1032. Section 1491, however, covers all transfers to foreign corporations and is not limited to transfers that constitute section 351 exchanges. Section 721, by contrast, governs all exchanges of property for a partnership interest. Notwithstanding these differences, we believe that the standards for an exchange of property for purposes of sections 721 and 351 are similar.

[12] Under section 351, no gain or loss will be recognized if one or more persons transfer property to a corporation solely in exchange for stock in the corporation and, immediately after the exchange, such person or persons are in control of the corporation. The Service interprets this language to mean that, under section 351, a person must "transfer property to a corporation solely in exchange for stock" in a manner consistent with section 1001. Consequently, if the rights to be transferred to the transferee corporation were sold to a third party for cash, gain or loss would have to be realized under section 1001 and section 61(a)(3) in order for the transfer to qualify for nonrecognition under section 351.

[13] Rev. Rul. 69-156, 1969-1 C.B. 101, illustrates the Service's position with respect to the granting of a nonexclusive license to use patent rights. In that ruling, the Service held that the grant of patent rights to a corporation in exchange for stock will constitute a transfer of property under section 351 only if the grant consists of all substantial rights in the patent and would constitute a sale or exchange of property rather than a license. See also Rev. Rul. 71-564, 1971-2 C.B. 179; Rev. Rul. 64-56, 1964-1 (Part 1) C.B. 133. The Service has applied a similar analysis to rights other than patents (see Rev. Proc. 83-59, 1983-2 C.B. 575, 578, sections 4.023(4)(copyrights and trade secrets) and 4.023(5) (franchises, trademarks, and trade names)), and we see no basis for distinguishing the rights transferred to the partnership by the taxpayer in the present case.

[14] Notwithstanding the above, serious consideration must be given to case law interpreting the Service's position, before proposing adjustments in the statutory notice of deficiency. In E.I. du Pont de Nemours & Co. v. United States, 471 F.2d 1211 (Ct. Cl. 1973), the United States Court of Claims held that a "carved out" right to a nonexclusive license would qualify for nonrecognition under section 351. In so holding, the court rejected the Service's position set forth in Rev. Rul. 69-156 and held that there is no basis for limiting nonrecognition under section 351 to transfers which constitute sales or exchanges under section 1001. Because du Pont was decided in the predecessor of the United States Court of Federal Claims, its precedential effect is not confined to a specific geographical area. Further, the Service has not successfully litigated any cases concerning this issue since 1973. See generally, J. Clifton Fleming, Jr., Domestic Section 351 Transfers of Intellectual Property: The Law as It Is vs. The Law as the Commissioner Would Prefer It to Be, 16 J. Corp. Tax'n 99 (1989).

[15] We also note that in United States v. Stafford, 727 F.2d 1043, 1048 (11th Cir. 1984), the court held that a partner's transfer of a letter of intent, which was unenforceable under state law, qualified for nonrecognition under section 721. In reaching this conclusion, the court relied on precedent under section 351 to determine the scope of the term "property" under section 721. The court reasoned that the purpose of section 721 is similar to the purpose of section 351, which is to facilitate the flow of property into entities which will use the property productively. Stafford at 1048.

ISSUE 2

[16] Section 1492(2)(B) allows taxpayers to avoid the excise tax imposed under section 1491 by making an election to have principles similar to section 367 apply to a transaction normally taxed under section 1491. The Service has not taken a public position on whether section 367(d) principles can be applied to a transfer of intangible property to a foreign partnership. However, the Conference Report to the Tax Reform Act of 1997 stated that such an election was available to transferors making such transfers to foreign partnerships prior to August 5, 1987. See H.R. Rep. No. 105-220, at 628 (1997).

[17] Although there is very little guidance on section 1492(2)(B) elections by virtue of regulations, published guidance, or case law, a straightforward reading of the statute indicates that the section 1492(2)(B) election is a method of avoiding the imposition of the excise tax imposed by section 1491. The section 1492(2)(B) election is not a broad election to apply section 367 principles to any taxable transaction and, therefore, does not apply to transactions that do not constitute a "transfer of property" for purposes of section 1491. Nevertheless, if there was a property transfer in this case, see Issue 1, supra, the taxpayer was eligible to elect to apply principles similar to section 367(d) to the technology transfer in this case.

ISSUE 3

[18] The Service has not issued regulations under section 1492(2)(B), as amended; however, the Service has stated in