Industry Director Directive on Section 936 Exit Strategies
LMSB Control No.: LMSB-04-0107-002
Impacted IRM 4.51.2
February 2, 2007
MEMORANDUM FOR INDUSTRY DIRECTORS
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR, INTERNATIONAL COMPLIANCE STRATEGY AND POLICY
FROM: John Risacher /s/ John Risacher
Retailers, Food, Pharmaceuticals, and Healthcare
SUBJECT: Tier I Issue - Industry Director Directive on Section 936
Exit Strategies # 1
This memorandum provides direction to the field concerning efficient use of examination resources relating to the audit of Section 936 Exit Strategies, which have been designated a Tier I compliance issue. As a result of this designation, LMSB-wide coordination and executive oversight is required to ensure appropriate examination coverage, and a consistent approach to the development and resolution of the issue. With the phase-out and ultimate termination of the section 936 credit, companies with qualifying operations in Puerto Rico have been faced with decisions regarding the restructuring of their section 936 corporations. In some cases, these restructurings become part of broader reorganizations of international operations, which may take or have taken place over a period of several years.
In general, Section 936 Exit Strategies address the offshore migration of intangibles under section 367 and the transfer pricing of U.S.-owned intangibles under section 482 that result from the restructuring of section 936 corporations. This directive and its related guidelines are intended to provide a uniform format and approach for examiners to evaluate potential compliance risk related to this issue; to outline the issue management and oversight process that has been established; and, to introduce an initial set of audit guidelines. This directive is relevant to the examination of taxpayers with both current and/or former section 936 operations. This directive is not an official pronouncement of law or the position of the Service and can not be used, or cited, or relied upon as such.
Section 936 (Footnote 1) provided a tax credit against US taxes imposed on income earned by a US corporation (usually referred to as the Possession Corporation), which conducted a trade or business in Puerto Rico. As the result of a ten year phase-out of tax benefits for taxpayers operating under section 936 that commenced in 1995, taxpayers cannot claim this tax credit for tax years beginning after December 31, 2005. The amount of income the possession corporation could earn was generally determined under the special rules in section 936(h)(5) (Cost-sharing and Profit-Split). These rules essentially limited the credit to the manufacturing profits from the operations in Puerto Rico. Profits attributable to marketing, or other similar activities, did not qualify for the credit.
Under a typical structure, the Possession Corporation was a wholly-owned US subsidiary of another US Corporation (usually referred to as the US Parent) (Footnote 2). The US Parent or its US affiliates, herein after referred to as US Parent, usually reported these marketing-related profits on its tax return, subject to full US tax rates. Thus, in a typical operation, the Possession Corporation performed the manufacturing activities and the US Parent performed the marketing activities. (The trade or business of a typical 936 company was solely manufacturing.) The products were generally sold to US or foreign affiliates. The manufacturing profits subject to the section 936 credit included the income attributable to the manufacturing activities, as well as the income attributable to the manufacturing intangibles, such as patents, know-how, etc. used by the Possession Corporation. Puerto Rico also granted a partial or complete credit against Puerto Rican taxes on this same income. The availability of these two tax credits (the section 936 tax credit and the Puerto Rican tax credit) resulted in a large portion of income earned from the manufacture and sale of the Possession Corporation products being completely exempt from tax.
The tax benefits provided by section 936 have been completely eliminated for tax years beginning after December 31, 2005. Because of the ten-year phase-out, the benefit received from the credit in the last few years may have been relatively small. Many companies began restructuring their operations, in an attempt to preserve historically low levels of taxation. These restructurings began for some taxpayers around 1999 and continued through 2006. While these restructurings may be appropriate, they present several issues, as described below.
Footnote 1: This discussion is not intended to provide a comprehensive review of section 936 and its related regulations, but rather to provide a general overview, as an introduction to the Section 936 Exit Strategies. Examiners should refer to section 936 and its related regulations for more detail.
Footnote 2: Although the Possession Corporation was generally a wholly-owned subsidiary of a US Parent, the Possession Corporation could not be a member of the US consolidated return, and thus, filed a separate Form 1120.
The reorganization of Possession Corporations could take several forms. The most common involves the formation of a controlled foreign subsidiary (CFC). The new CFC is usually incorporated in low tax jurisdiction. The Puerto Rican manufacturing operations are organized as a branch of this new CFC.
Typically, the reorganization involves a section 351 transfer (or in some cases a section 361 transfer as part of a reorganization) of the tangible assets used in the Puerto Rican manufacturing operations from the Possession Corporation to the new CFC. The tangible assets consist mainly of plant, equipment, accounts receivable, inventory, etc. Section 367(d) prevents a tax free transfer of intangible assets to a foreign corporation, except for foreign goodwill and going concern. Therefore, the intangible assets are usually not included in the section 351 transfer (or the section 361 transfer), but rather licensed by the US Parent to the new CFC. This license grants the new CFC the rights to use the intangible assets and does not represent a transfer subject to section 367(d). There are also charges for other controlled transactions such as services, marketing and distribution activities, and other manufacturing activities conducted by the US Parent for the new CFC. The amount of the royalty payable for the use of the assets and charges for the other activities is determined under section 482. See IRS Notice 2005-21 for additional information.
Before restructuring, all income relating to the Puerto Rican operations was reported by either the US Parent or the Possession Corporation on their respective US returns, but that income was subject to the section 936 credit. After restructuring, the Parent reports income for the royalties received and charges for the other controlled transactions. The new CFC reports income from the exploitation of the licensed intangibles and from its functional activities (such as its manufacturing operations). This income is taxed by the foreign government(s) and is deferred from US taxation.
Globalization is a key strategic initiative of the LMSB division, with a significant focus on the migration of intangibles and transfer pricing. Economic activities have become increasingly integrated throughout the multinational enterprise. Globalization has increased the complexity and sophistication of international business planning. The phase out of the section 936 credit for certain operations in Puerto Rico occurred concurrently with these international business trends.
Thus, many of the companies that had historically operated in Puerto Rico, and enjoyed the tax benefits of section 936, undertook to realign their international structures as these tax benefits phased out. This planning can be entirely proper. However, some of these plans can have a substantial impact on income subject to US taxation, and therefore this is an area of potential risk that should be considered during the audit planning process.
Potential issues resulting from the termination of section 936 can cut across multiple code sections. The type and number of issues may vary depending on the particular situation of the taxpayer under examination. As a result, a specific Uniform Issue Listing (UIL) code has not been assigned. Rather, the UIL code that reflects the specific issue(s) resulting from the restructuring of section 936 operations should be used. In order to track the issue, all examiners must also use the Secondary Standard Audit Index Number (SAIN), 240, in conjunction with the issue-specific UIL code.
If an issue and/or issues under examination involve section 482 and/or section 367, potential issue tracking codes may include, but are not limited to:
|Section 482:||UIL Code||
|Transfer and Use of Intangibles||482.11-00||
|Cost Sharing Arrangements||482.11-08||
|Section 367:||UIL Code||
|Transfers of Intangibles to CFCs under section 367(d)||367.30-00||
|Property Subject to section 367(a)||367.05-00||
Other issues may arise that are beyond the scope of this directive, such as subpart F and foreign tax credit issues as well as issues under section 367(a). Under those circumstances, the same principle of using the issue specific UIL code and the Secondary SAIN of 240 designated for section 936 Exit Strategies should apply.
Teams with cost sharing issues under Treas. Reg. § 1.482-7 should also refer to guidance provided by the Cost Sharing Issue Management Team (IMT), including an examination checklist for cost sharing arrangements released in 2005.
Planning and Examination Guidance:
The significance of transfer pricing and valuation issues, particularly those related to the transfer and use of intangible property under section 367 and 482 has been magnified with the restructuring of international operations, in general, and of former Possession Corporations, in particular. The following are key categories of issues addressed under this directive.
- Determination of Arm’s Length Royalty to the US Licensor.
- Determination of the proper transfer prices for the other associated intercompany charges for services, marketing and distribution activities, and other manufacturing activities conducted by the US Parent.
- Taxation under section 367(d) for any intangibles transferred to the new CFC.
1. Determination of Arm’s Length Royalty to the US Licensor:
The valuation of the royalty represents a significant potential audit issue. At the time of the restructuring, the US Parent is usually the owner of all significant intangible property related to the Puerto Rican operations. So, any value attributable to that intangible property should be reflected in the royalty paid by the CFC to the US Parent. In most cases examined to date, the extraordinary profits generated by the new CFC are attributable to that intangible property. The CFC may have taken on some or all the entrepreneurial risks and responsibilities as a licensee of the intangible assets. To the extent that it has, the royalty should reflect the contributions of both the US Parent and the new CFC. In many cases, it has been observed that the CFC retains an inordinate amount of the profits, i.e., amounts in excess of what would be expected, based upon activity.
The royalty is a payment for the use of intangible property. In most cases the US Parent or the Possession Corporation created almost all of the relevant intangible property (footnote3). As a result of the reorganization, the owner of most of the intangible property is generally the US Parent (unless such intangible property was transferred to the CFC pursuant to sections 351 or 361, which will be discussed in the next section). The CFC, being newly created, initially could not have contributed to the development or value of these intangible properties. This does not mean, however, that all of the income attributable to these intangible properties should go to the US Parent. The legislative history indicates that the division of profits between the transferor and the transferee must reasonably reflect the economic activities that each undertakes. In most cases, these intangible assets are the major contributor to the extraordinary profits and they represent the primary contributions of the US Parent to the new CFC. The new CFC should proportionately share in the profits, to the extent it has assumed the entrepreneurial risks and responsibilities as a licensee of the intangible assets. In some cases, the CFC may have been formed some time prior to the conversion. If this CFC was a participant in a cost sharing arrangement under Treas. Reg. § 1.482-7, it will in effect be deemed to own some of the intangibles. This will have to be considered in determining the division of profits.
Indicators of Potential Issues May Include:
a. New CFC reports a substantial portion of system profit.
b. Operating margins of the new CFC appear unreasonable.
c. Division of Profits is based on industry standards or so-called “rules of thumb” for licenses of intangible property.
d. US Parent incurs most operational costs, such as R&D, manufacturing, marketing and distribution, and other service costs – but receives a small portion of residual profits.
e. US Parent does not receive enough profits to fund ongoing R&D that provide future intangibles to be licensed to the new CFC.
f. Taxpayer has not provided a fair market value (FMV) for assets transferred as part of the section 351 (or section 361) transfer(s).
g. If the taxpayer has provided a FMV for assets transferred as part of the section 351 (or section 361) transfer(s), the value is low compared to the profits reported by the new CFC.
Footnote 3: Even if the Possession Corporation made a cost sharing payment to the US Parent under section 936(h), that payment would not have provided the Possession Corporation with any interest in any manufacturing intangibles owned by the US Parent. Rather, the cost-sharing payment simply entitled the Possession Corporation to be treated as an owner of manufacturing intangibles for purposes of computing income under section 936.
2. Determination of the Proper Transfer Prices for the Other Associated Inter-Company Charges for Services, Marketing and Distribution Activities, and Other Manufacturing Activities Conducted by the US Parent:
Controlled transactions may be present in addition to the license of intangibles after the restructuring of the section 936 operations:
a. The CFC/Licensee may or may not have taken on significant entrepreneurial risks and responsibilities regarding the licensed intangibles. The extent and amount will influence the royalty and the amounts charged for other functions performed by the US Parent for the CFC. The new CFC generally will have only two types of assets: (1) the manufacturing assets received in the section 351 transfers and (2) the license with the US Parent. Other than the Puerto Rican workforce in place that was presumably acquired in the section 351/361 transfers, there are generally a limited number of other employees, facilities, etc.
b. The license may grant the CFC the right to manufacture and sell the Puerto Rican products. Puerto Rico may not manufacture the complete product; some elements may be manufactured by the US Parent or other affiliates. The actual marketing and selling functions may be performed by affiliates. Planning, oversight and all management activities not related to manufacturing would generally be performed for the CFC. In some cases R&D is performed by the US Parent. All these activities give rise to controlled transactions other than licenses of intangible property.
c. To determine arm’s length charges for all of these transactions, the risks and responsibilities assumed by each party must be evaluated, together with the other intangibles used in the activity – for instance, are valuable marketing intangibles used by the US Parent in the selling activity or are valuable R&D intangibles used in the R&D activity?
d. Another question is whether each activity should be looked at in isolation. Taxpayers often take the position that each activity must be looked at in isolation, i.e., the US Parent is a contract service provider for R&D; the US Parent is a contract management service provider; the US Parent is a limited risk distributor for the Puerto Rican products, etc. The taxpayer, however, often has worldwide operations. Each of these activities has a synergy with other group activities, with the result that particular activities may enhance the value of other activities. Consequently, it may be inappropriate to evaluate each activity in isolation.
e. The factors and questions above, in addition to others that may arise, will influence the arm’s length charges for these intercompany transactions as well as other intercompany transactions.
This represents an introduction to the issues that may have to be addressed.
3. Taxation under Section 367(d) for Any Intangibles Transferred to the New CFC:
Rather than licensing intangible property to the new CFC, the US Parent may transfer intangibles to the CFC in an exchange to which section 351 or 361 applies. Such transfers generally will be subject to section 367(d). As a result, the US Parent will be treated as having sold the intangible property to the CFC in exchange for contingent annual payments over the useful life of the property. As with the royalties the US Parent would receive from a license of an intangible to the CFC, the deemed annual payments reported by the US Parent in a section 367(d) transaction must be commensurate with the income attributable to the intangible. That is, the amount of the section 367(d) payments must be determined under section 482 principles. Accordingly, the issues described in section 1 above relating to the valuation of the royalty paid to a US licensor also are relevant to transfers subject to section 367(d).
In a significant exception to the general rule, transfers of foreign goodwill and going concern value in outbound section 351 and 361 exchanges are not subject to tax under section 367(d). The existence of this exception often leads US transferors to contend that a significant portion of the intangibles transferred in a section 351 or 361 exchange, particularly marketing intangibles and workforce in place, should be treated as foreign goodwill and going concern value. Such claims should be carefully scrutinized, and the nature of all transferred intangibles should be examined to determine whether it would be more appropriate to treat the claimed foreign goodwill and going concern value as intangibles subject to section 367(d). Likewise, in the case of section 936 conversions, it may be appropriate to consider whether claimed foreign goodwill and going concern value is really foreign. It may be that these intangibles are goodwill and going concern value, but are not foreign and thus are subject to tax.
Steps to Determine if Potential Issue Exists:
- Section 936 possession corporations are US Corporations and are required to file a separate US tax return. This would be a separate Form 1120. A Possession Corporation cannot be part of a consolidated Form 1120.
- Determine if your taxpayer currently or previously filed a Form 1120 for a Possession Corporation under section 936.
- Determine if the Possession Corporation has reorganized, either partially or in full, its Puerto Rican operations in the manner described above.
a. If taxpayer has or had a possession corporation, determine if a cost sharing election was made under section 936(h). Secure and review any prior examination reports that may exist to determine if issues were raised regarding the royalty or intercompany transfer prices.
b. Review transfer pricing documentation studies prepared pursuant to section 6662(e).
c. Be particularly aware of operations in Puerto Rico.
d. Review Forms 5471 for newly incorporated CFC’s (possibly in low-tax jurisdictions.)
e. Look for large amounts of income/profits generated by the CFC in a low tax jurisdiction.
f. Review Forms 1120 for section 351/361 disclosure statements identifying assets transferred to the newly formed CFC. These disclosures should include total fair market valuation for all assets transferred (tangible and intangible), as well as individual fair market value for each and every separately identifiable asset (tangible and intangible).
g. Review Forms 926 attached to return for fair market valuation of transfers of intangible property to the newly formed CFC.
- Submit Pro-Forma IDR.
Suggested Examination Resources to Examine Issue:
Development of these issues is potentially complex and requires substantial expertise in international taxation and economic analysis.
- Request assistance of an International Examiner if one is not already assigned.
- Examiners are required to submit a referral for IRS Economist assistance.
- Inability to obtain the assistance of an International Examiner and IRS Economist may affect the strength/viability of any proposed adjustment. This should be considered as part of the case risk analysis.
- Consider assistance from International Technical Advisors, or other technical members of the Section 936 Exit Strategies IMT.
- In conjunction with an IRS Economist, consider need for Outside Expert Assistance for large and complex cases.
- In conjunction with an IRS Economist, consider need for assistance from an IRS Engineer for the functional analysis of the operations and valuation issues.
- Request assistance of local LMSB Counsel.
Planning and Examination Risk Analysis:
An Issue Management Team (IMT) has been established to ensure appropriate examination coverage and a consistent approach to the development and resolution of issues related to Section 936 Exit Strategies. The following outlines the risk analysis and issue management process that has been established by the IMT for this purpose.
Cases selected for mandatory examination:
The team should determine if the taxpayer converted (Footnote 4) its historic section 936 operations. (Mandatory examination cases have been or will be directly notified.) The following steps should be taken:
- If the taxpayer did not convert its section 936 operations, then the issue must be examined during the cycle in which the transfers took place.
- If the taxpayer converted its section 936 operations during the current and/or prior cycles, and the Estimated Closing Date (ECD) of the current examination is:
a. During FY 2007, the team need not examine the issue until next cycle, unless the issue is already under examination or has already been selected for examination. Under such circumstances, the team should follow the audit guidelines accompanying this directive, and the review and oversight process established by the IMT and outlined in the section below.
b. During FY 2008, the issue must be examined and teams should follow audit guidelines, review and oversight process.
Footnote 4: For purposes of this discussion, “conversion” also includes partial transfers of assets, which may have taken place over several years.
Compliance Assurance Process (CAP) cases:
If the Taxpayer converts its section 936 operations during 2006/2007 CAP years, the team must address this issue according to the audit guidelines presented in this directive, and the IMT review and oversight process.
All remaining cases with former and/or current section 936 operations:
The team should follow the risk analysis process to establish if potential issues under sections 367 and/or 482 should be pursued. If the issue(s) is to be examined, teams should follow the issue identification and audit guidelines presented in this directive, including the mandatory review and approval process.
IMT Oversight Process:
An IMT Oversight Committee, which includes representatives from the Retailers, Food, Pharmaceuticals, and Healthcare (RFPH) Industry, Prefiling and Technical Guidance (PFTG), and the Field Specialist(s), has been established to review and approve all issues under examination that are related to section 936 Exit Strategies. Accordingly,
- All Form 5701 proposed adjustments must be reviewed and approved by the IMT Oversight Committee.
- All final resolutions at the field level must be reviewed and approved by the IMT Oversight Committee.
Teams should contact Jolanta Sander, RFPH Senior Program Analyst/Economist at (630) 493-5935 or Jolanta.B.Sander@irs.gov for coordination of the review and oversight process.
The attached audit guidelines outline the framework and resources to assist examiners addressing issues related to the migration and use of intangibles under sections 367and 482 that may result from activities related to the termination of section 936. As this initiative evolves, further examination guidance may be developed to supplement that provided in this directive and accompanying guidelines.
Cc: Commissioner, LMSB
Deputy Commissioner, LMSB
Deputy Commissioner, International
Division Counsel, LMSB
Director, Performance, Quality and Audit Assistance