On September 23, 2022, the Internal Revenue Service (IRS) released a memorandum (AM 2022-003) concluding that taxpayers cannot make advance payments of section 367(d) inclusions except in the limited situation in which the US transferor receives boot in connection with the initial transfer of intangible property (IP) to a foreign corporation. The memorandum is relevant to any taxpayers who made, or are considering making, advance payments of section 367(d) amounts. In our view, the memorandum (which does not have precedential value) is not persuasive, and both its reasoning and its conclusion are inconsistent with prior IRS guidance and analogous long-standing case law.
OVERVIEW OF SECTION 367(d) AND NOTICE 2012-39
Section 367(d) generally provides that when a US person (USP) transfers IP to a foreign corporation in an otherwise tax-free exchange under sections 351 or 361, the US transferor is treated as having sold the IP in exchange for contingent payments and receiving amounts which would have been received annually in the form of such payments. The amounts included in the US transferor’s income (i.e., the section 367(d) inclusions) are treated as ordinary income and royalties for purposes of determining the source and foreign tax credit limitation category. See sections 865(d)(1)(B) (source); 367(d)(2)(C) (foreign tax credit limitation category). See also section 904(d)(3)(A); Reg. §1.904-5(b) (look-through rules).
In Notice 2012-39, the IRS treated boot received in an outbound section 367(d) transaction as an advance payment of the section 367(d) inclusion. In the Notice, the IRS described a situation in which a US Parent (USP) owns a US company (UST) with a basis and value of $100, and UST owns IP with a basis of $0 and a value of $100. Pursuant to an “all-cash D” reorganization, UST transferred IP with a value equal to $100 to a controlled foreign corporation (CFC) owned by USP in exchange for $100 and then UST distributed the cash to its USP in liquidation. As described in the Notice, UST would report the $100 received from CFC as tax free under section 361, and USP would report no dividend income or gain from receiving the $100 cash under the “gain within boot” rule in section 356(a)(1) (because there was no built-in gain in the stock of UST). According to the Notice, taxpayers would take the position that “the transactions have resulted in a repatriation in excess of $100x ($100x at the time of the reorganization and then through repayment of the receivable in the amount of USP’s income inclusions over time) while only recognizing income in the amount of the inclusions over time.” Thus, USP could receive, for example, $200 of cash ($100 from the initial transfer and $100 over time related to the section 367(d) inclusions) but only include $100 in income (over time on the section 367(d) inclusions).
To address what the IRS and the US Department of the Treasury perceived to be an inappropriate repatriation of cash, the Notice provided that in such a situation, the $100 received by UST in the initial outbound section 367(d) transaction is treated as an advance payment of the deemed section 367(d) royalties, resulting in immediate ordinary income for UST (and thus a later payment of $100 of cash would be subject to the normal distribution rules and not excluded from income pursuant to section 367(d)).
In earlier guidance, the IRS also treated cash boot received in connection with outbound section 351 transfers as prepaid deemed royalties and an immediate section 367(d) income inclusion for the US transferor in CCA 200610019 and PLR 2008845044. In reaching its conclusion, the IRS stated in CCA 200610019: “To the extent that this amount exceeds the §367(d) payment for the year, it is treated as an advance payment on the future §367(d) income and is included in income in the year it is received.”
For the first time, AM 2022-003 argues that taxpayers should not be able to accelerate section 367(d) inclusions through advance payments in any case other than where the payment is made at the time of the initial outbound transfer. The memorandum asserts that section 367(d)’s underlying policy is that, instead of recognizing gain upfront, the US transferor should have an annual section 367(d) inclusion determined by reference to the exploitation of the IP annually over its useful life. However, even when advance payments are made, the section 367(d) amount is determined by reference to the exploitation of the IP annually over its useful life. An advance payment merely means that the amount is included in the US transferor’s income in an earlier year.
Additionally, the IRS argues that because neither section 367(d) nor the relevant regulations explicitly provide for advance payments, no section 367(d) amounts can be included in income as an advance payment if made any time after the initial outbound transaction. The IRS further argues that because a section 367(d) transaction is not a licensing arrangement, the fact that taxpayers generally can make advance payments of royalties in licensing arrangements is irrelevant. Though there are differences between licensing arrangements and section 367(d) transactions, the differences do not compel a conclusion that advance payments of section 367(d) inclusions cannot be made. Indeed, Congress has provided similar tax treatment by expressly treating section 367(d) inclusions as royalties for purposes of determining their source and foreign tax credit category. And in the section 367(d) context, existing guidance (described above) establishes that advance payments can, in fact, be made.
The IRS additionally states that advance payments of section 367(d) amounts would raise administrative concerns because such an approach would require the IRS to “evaluate whether a purported advance payment ultimately captured undetermined amounts of future inclusions.” However, advance payments do not raise any administrative concerns other than those already raised by the payment of boot in the scenarios described in Notice 2012-39 and other prepayment situations. For example, the amount of an advance payment allocated to section 367(d) inclusions for future years would need to be determined, regardless of whether the advance payment was a payment of boot upon an initial transfer of the IP.
Moreover, the IRS attempts to distinguish Notice 2012-39 by limiting it to outbound transfers of IP in exchange for boot. The IRS states that in a situation involving a prepayment that is not in connection with an initial section 367(d) transfer, “there is no transfer of boot in respect of intangible property, no policy concern regarding repatriation, and section 367(d) clearly applies.” The IRS’s attempt to distinguish the Notice is not persuasive. The policy concern described in the Notice of the amount of repatriation exceeding income inclusions was addressed by treating cash received as a prepayment of section 367(d) amounts (thus, the US taxpayer would have $100 income on $100 cash repatriation through the prepaid section 367(d) amounts). With respect to a prepayment after an initial transfer, this policy concern is similarly addressed by respecting cash received as a prepayment of section 367(d) amounts (thus, the US taxpayer would have $100 income on $100 cash repatriation through the prepaid section 367(d) amounts). In addition, as noted above, a prepayment of a section 367(d) amount is still within the purview of section 367(d); it is just an acceleration of the income inclusion under section 367(d).
Respecting advance payments of section 367(d) amounts as prepayments of future section 367(d) amounts is consistent with principles found in general tax law regarding the treatment of prepayments. Well-established, long-standing precedent provides that prepayments generally are taken into account currently by the payee and respected as prepayments. (See, e.g., Schlude v. Comm’r, 372 U.S. 128 (1963) (cash paid to a dance studio for lessons was included in income when the cash was received, not when the lessons were provided); American Automobile Ass’n v. United States, 367 U.S. 687 (1961) (prepaid membership dues were included in income when the dues were received, even though the dues related to services for future years); Karns Prime & Fancy Food v. Comm’r, 494 F.3d 404 (3d Cir. 2007) (amounts constituted income when received because the taxpayer’s right to keep the funds depended solely on its compliance with a supply agreement). Cf., Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990) (“From the moment an advance payment is made, the seller is assured that, so long as it fulfills its contractual obligation, the money is its to keep.”).)
AM 2022-003 is important because it provides the IRS’s current views concerning the treatment of a prepayment of section 367(d) amounts. The IRS confirms that it interprets section 367(d) and the regulations as providing that a prepayment can be made for section 367(d) inclusions upon the initial transfer of the IP to a foreign subsidiary. By seeking to distinguish prepayments of royalties, AM 2022-003 appears to accept that royalties can be prepaid, which generally would be treated the same to a US taxpayer as an advance payment of section 367(d) amounts.
AM 2022-003 also lays out the IRS’s current position that taxpayers cannot make advance payments of section 367(d) amounts after the year of transfer. There is no basis in the Internal Revenue Code or regulations for distinguishing such advance payments from initial advance payments, and such a position diverges from the prior approach taken by the IRS in Notice 2012-39 and other existing guidance. Taxpayers who already made advance payments of section 367(d) inclusions should be aware of the memorandum and prepared to challenge the IRS’s position. Other taxpayers should understand the IRS’s position before deciding to make such advance payments.