Outbound Transfers of Appreciated Property by U.S. Persons to Foreign Corporations: Avoiding the Pitfalls
With the ever-increasing size of the global economy, more privately owned American companies are engaging in business operations outside of the United States. Whether the particular activity being set up outside of the US is capital and/or labor intensive, frequently the legal and tax advisors for the US company will recommend the formation of a foreign corporation be established in each jurisdiction in which the company intends to carry on business operations through a permanent establishment. There may be a variety of reasons offered for such recommendation. Still, in some instances use of a foreign partnership or "hybrid" entity may be more suitable.
Still where a foreign corporation is the desired entity choice, the first issue is to what extent materials, capital and labor will be used in the foreign location. Transfers of assets to a controlled foreign corporation does not always have a tax-free consequence. Ineed, the transfer of appreciated assets to a foreign corporation must run through the requirements under section 367 in order to determine whether and to what extent the transfers are non-taxable.
Section 367(a)(1) provides, subject to certain exceptions, that transfers of appreciated property to a foreign corporation will not qualify as a tax-free exchange for stock under section 351. Instead, gain must generally be recognized where the transferee is a foreign corporation. Exceptions are provided by the Code and in the regulations.
One of the more notable exceptions is made with respect to outbound transfers of stock or securities to a foreign corporation which is part of an overall reorganization or tax free exchange of stock. This is set forth under section 367(a)(2).
Another and perhaps broader exception is for transfers of property to a foreign corporation that will be used by the foreign corporation in the active conduct of a trade or business outside of the US. §367(a)(3). There are some types of property which will not qualify as part of the active trade or business exception. Such list includes inventory, installment obligations, accounts receivable, foreign currency intangible property, and property being leased by the transferor (except where leased to the transferee). Still, the incorporation of a foreign branch by transfer of its assets to a foreign corporation will result in the recapture of the excess foreign losses.
Section 367(a)(1) reaches out to tax transfers of appreciated property by a domestic partnership to a foreign corporation unless an exception can apply. This is treated as an indirect transfer of the assets by the partners.
Intangibles transferred to a foreign corporation present a major trap for the unwary. Generally, where a transfer of intangible assets is made to a foreign corporation, the transferor will generally be treated as having sold or transferred the intangible for payments which are contingent upon the productivity, use or disposition of the property. Thus, under section 367(d), the U.S. transferor of such intangibles must including in gross income each year over the useful life of the intangible or intangibles involved, an amount which reflects the amount which would have been received in the intangible(s) were sold. §367(d). In many instances it is far more preferable to license intangibles to the foreign based entity. Until regulations are issued, transfers of intangibles to entities taxable as partnerships do not run afoul of section 367(d).
Also under section 367(e) and accompanying regulations, gain is required to be recognized in two prescribed instances: (i) a US subsidiary corporation is required to recognize gain on the distribution of its assets to a foreign parent corporation and a foreign subsidiary which is also engage in a liquidation must also generally recognize gain in transferring its US business assets to its foreign parent corporation, subject to pertinent exceptions; and (ii) a US corporation which transfers the stock or securities of a controlled corporation recognizes gain to the extent such stock or securities are distributed to a foreign corporation.
The point being made in this short entry is that businesses seeking to expand their operations overseas must be advised from the inception of the expansion plan by tax counsel to ensure that the overall tax structure selected is sound, known in advance, and the associated costs are budgeted and predictable. The starting line in many cases is section 367. While this provision has many twists and turns that obviously could not be touched upon with any detail or completeness in this short message, it is also important to warn that there are indeed many other substantial tax considerations that touch upon planning for the expansion of business operations overseas.
