On January 31, 2022, the Tax Court issued the full opinion in TBL Licensing LLC v. Commissioner (158 T.C. No. 1). The primary issues presented in TBL Licensing LLC v. Commissioner were (a) whether the petitioner was required to recognize gain in the intangible property as a result of a reorganization, and (b) whether the reorganization was a disposition within the meaning of IRC § 367(d)(2)(A)(ii)(II).

Background to TBL Licensing LLC v. Commissioner

The deficiency in this case is $505 million. Yikes.

The primary question presented was whether the petitioner recognized ordinary income as a result of a constructive transfer of intangible property to a Swiss subsidiary/holding company—and, if so, whether the intangible property should be treated as having a useful life of only 20 years. Both parties moved for summary judgment. The IRS emerged the victor.

Two primary players were involved in this corporate restructuring: VF Corp (the manufacturer of Lee, Wrangler, Nautica, Vans, and the North Face) and Timberland Co. (the manufacturer of…well…Timberland). VF and Timberland were combined in September 2011, by merging an acquisition subsidiary of TBL International Properties, LLC (International Properties) into Timberland.

In the merger, the former Timberland shareholders received cash in exchange for their Timberland stock. VF had organized IP in August 2011 as a limited liability company under Delaware law. IP was a disregarded entity. This foreign restructuring may remind readers of the gyrations the petitioner in Whirlpool Financial Corporation v. Commissioner, 154 T.C. No. 9, went through…

The petitioner in the present case, TBL, is also a Delaware limited liability company (taxed as a corporation) whose sole shareholder was IP. Before the merger in which IP acquired Timberland, VF transferred its membership interest in IP to VF Enterprises, an indirect foreign subsidiary of VF. As part of the post-acquisition restructuring, the petitioner came to own Timberland’s intangible property, including trademarks, foreign workforce, and foreign customer relationships.

Shortly after the close of the merger by which IP acquired the Timberland stock (and after the petitioner had acquired Timberland’s intangible property), VF Enterprises contributed the sole member interest in IP to TBL GmbH. About a week later, the petitioner elected under Treas. Reg. § 301.7701-3(c)(1)(i) to be disregarded as an entity separate from its owner.

On the Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, included with its Federal income tax return for the taxable year ended September 23, 2011, the petitioner reported that the trademarks it acquired from Timberland had a fair market value of $1,274,100,000. The IRS assigned the same value to the trademarks in computing the deficiency in issue.

Lee Bell, Inc. (Lee Bell), an indirect domestic subsidiary of VF and indirect parent of VF Enterprises, reported income under IRC § 367(d)(2)(A)(ii)(I) for the taxable years 2011 through 2017, which arose from the petitioner’s constructive transfer of intangible property to TBL.

In the restructuring that followed the acquisition of Timberland by VF Enterprises, through IP, the petitioner came to own Timberland’s intangible property and then made a constructive transfer of that property to TBL GmbH, a subsidiary of VF Enterprises. The petitioner’s constructive transfer of intangible property occurred as part of a “reorganization” described in IRC § 368(a)(1)(F).

Because the petitioner—then treated as a U.S. corporation—constructively transferred intangible property to a foreign corporation in a transaction that would otherwise qualify for nonrecognition treatment under IRC § 361(a), IRC § 367(d) applies to the transfer. The disagreement between the parties, however, was as to the consequences of IRC § 367(d)’s application.

The Nutshell Version of IRC § 367

When one of the parties to a transaction is a foreign corporation, affording the transaction the same nonrecognition treatment it would receive if the parties were domestic could lead to inappropriate results. When foreign corporations are involved, property can move in and out of the U.S. tax jurisdiction. Thus, reflecting those changes in status requires adjustments to the normal nonrecognition rules.

In particular, a U.S. person who makes an “outbound” transfer of property to a foreign corporation might be required to recognize gain even if, had the transfer been made to a U.S. corporation, it would have been entitled to nonrecognition treatment. IRC § 367(a), which applies to outbound transfers of most types of property, achieves that result by providing, subject to significant exceptions, that the foreign corporation that receives the property is not treated as a corporation.

Outbound transfers of intangible property are not covered by IRC § 367(a). Instead, they are instead addressed by IRC § 367(d), which generally requires a U.S. transferor of intangible property to recognize gain in the form of ordinary income. However, the timing of that income recognition varies depending on the circumstances. The principal dispute between the petitioner and the IRS centers on the timing of the income recognition required by IRC § 367(d).

Recharacterizing the Transaction in TBL Licensing LLC v. Commissioner

The parties’ disagreement concerning the effect of IRC § 367(d) turns, in part, on the proper characterization of the larger transaction. The actual transaction must be recharacterized for Federal income tax purposes; however, the parties disagreed on how.

To summarize the transaction

1. VF Enterprises, an indirect foreign subsidiary of VF, contributed to its own foreign subsidiary (TBL GmbH), the sole member interest in IP. IP then owned the sole member interest in the petitioner, and the petitioner owned intangible property that it had acquired from Timberland.
2. The petitioner then elected to be disregarded as an entity separate from its owner, IP (which, in turn, was disregarded as an entity separate from TBL GmbH).

That is the extent of the actual events that gave rise to the dispute before the Tax Court. These events did not include a transfer of intangible property. When the two-step process described above was completed, the petitioner continued to own the Timberland intangible property. However, both parties agree that the petitioner should be treated as having made a transfer of intangible property to which IRC § 367(d) applies.

The Tax Court notes, however, that in such types of corporate restructuring and recharacterization, the actual effect of the events is a tad more complex and must proceed in stages.

The First Stage: The Impact of the Entity Classification Regulations

As a domestic “eligible entity” with a single owner, IP would have been classified as a disregarded entity unless it had made an election to be classified as a corporation.^[1] IP has always been disregarded, and it made no election to be classified as a corporation. The petitioner was treated as a corporation throughout the taxable year in issue, and the petitioner initially filed an election under Treas. Reg. § 301.7701-3(c)(1)(i) to be classified as a corporation.^[2]

Because IP was disregarded, and the petitioner was classified as a corporation, VF Enterprises’ contribution to TBL GmbH of the sole member interest in IP should be treated as a contribution of “stock” in the petitioner.

The Second Stage: The Second Entity Election

Once the initial restructuring had occurred, the petitioner made a second entity election to be disregarded as an entity separate from its owner. As a general matter, an eligible entity cannot make more than one entity classification election every five years. ^[3] However, the limitation does not apply to “[a]n election by a newly formed eligible entity that is effective on the date of formation,”^[4] such as this election was.

Treas. Reg. § 301.7701-3(g)(1)(iii) describes the effect of an entity with a single owner that had been classified as an association electing to be disregarded. In that event, the association distributes all of its assets and liabilities to its single owner in liquidation of the association.^[5] Thus, the actual transaction would be recharacterized as a (i) contribution by VF Enterprises to TBL GmbH of the stock of the petitioner (then a corporation), followed by (ii) the petitioner’s distribution of all of its assets and liabilities to TBL GmbH in liquidation.

Thus, the petitioner would be treated as having transferred intangible property. However, that transfer—a liquidating distribution to TBL GmbH—would not have been a transfer to which IRC § 367(d) applies. This is so, because IRC § 367(d) applies to a transfer of intangible property by a U.S. person to a foreign corporation only if the transfer takes the form of “an exchange described in IRC § 351 or IRC § 361.”

For an exchange to be described in IRC § 351 or IRC § 361, it must be a transfer of property in exchange—at least in part—for stock of the recipient. Under the regulations, the petitioner would not be treated as having received TBL GmbH stock in exchange for the transferred intangible property.

Instead, the petitioner would be treated as having distributed the intangible property in liquidation—in cancellation of its own stock. Because the parties agree that the petitioner made a transfer of intangible property to which IRC § 367(d) applies, this is not the end of the recharacterization story.

Stage Three: Further Recharacterization Under the Reorganization Tax Court Rules

The next stage of recharacterization results from the application of the reorganization rules to the transactions imputed under the entity classification regulations. The parties agree that the transaction constituted was an “F reorganization” under IRC § 368(a)(1)(F), which includes within the definition of “reorganization” “a mere change in identity, form, or place of organization of one corporation, however effected.”

In 2015, the Treasury Department issued regulations that elaborate on that sparse statutory definition.^[6] By its terms, however, Treas. Reg. § 1.368-2(m) “applies to transactions occurring after 2015.^[7] Thus, the regulations do not apply to this transaction. For periods before the current regulations were effective, elaboration on the statutory definition was left to the courts.

One leading case stated:

[I]t is apparent from the language of subparagraph (F) that it is distinguishable from the five preceding types of reorganizations as encompassing only the simplest and least significant of corporate changes. The (F)-type reorganization presumes that the surviving corporation is the same corporation as the predecessor in every respect, except for minor or technical differences….

For instance, the (F) reorganization typically has been understood to comprehend only such insignificant modifications as the reincorporation of the same corporate business with the same assets and the same stockholders surviving under a new charter either in the same or in a different State, the renewal of a corporate charter having a limited life, or the conversion of a U.S.-chartered savings and loan association to a State-chartered institution.

The decisions involving subparagraph (F) or its counterpart in prior revenue acts consistently have imposed at least one major limitation on transactions that have been claimed to qualify thereunder: if a change in stock ownership or a shift in proprietary interest occurs, the transaction will fail to qualify as an (F) reorganization.^[8]

The Tax Court, therefore, found that VF Enterprises’ contribution of the sole member interest in IP to TBL GmbH and the petitioner’s election to be a disregarded entity resulted in a reorganization described in IRC § 368(a)(1)(F). This characterization is consistent with the caselaw interpreting that section of the Code. TBL GmbH emerged from the as “the same corporation” as the petitioner “except for minor or technical differences.”^[9]

VF Enterprises’ transfer to TBL GmbH of the stock of the petitioner and the deemed liquidation of the petitioner into TBL GmbH simply reincorporated the petitioner’s business. After the transactions, TBL GmbH owned “the same assets” and had “the same stockholder” as the petitioner. The petitioner’s business survived in a new legal form, albeit incorporated in Switzerland rather than Delaware.

But wait, there’s more to the recharacterization…

Stage Four: The Tax Consequences of the F Reorganization

IRC § 368(a) is only a definitional provision; it describes those transactions that qualify as reorganizations but does not itself prescribe their tax consequences. The operative rules are found elsewhere. IRC § 354 and IRC § 356 provide nonrecognition treatment, in whole or in part, at the shareholder level, and IRC § 361 provides nonrecognition treatment at the corporate level.

Fitting an F reorganization within the operative nonrecognition rules requires that the transaction—however actually effected—be treated as a transfer of assets by the old corporation to the new in exchange for stock of the new corporation and the old corporation’s distribution of that stock to its shareholders. Under this construct, the old corporation’s asset transfer will qualify for nonrecognition treatment under IRC § 361(a) and the stock distribution will qualify for nonrecognition treatment under IRC § 361(c). The shareholders’ exchange of stock of the old corporation for that of the new will receive nonrecognition treatment under IRC § 354(a).

Treas. Reg. § 1.367(a)-1(f) confirms that the above construct applies at least to F reorganizations in which “the transferor corporation is a domestic corporation, and the acquiring corporation is a foreign corporation.” In those circumstances there is considered to exist—

1. A transfer of assets by the transferor corporation to the acquiring corporation under IRC § 361(a) in exchange for stock (or stock and securities) of the acquiring corporation and the assumption by the acquiring corporation of the transferor corporation’s liabilities;
2. A distribution of the stock (or stock and securities) of the acquiring corporation by the transferor corporation to the shareholders (or shareholders and security holders) of the transferor corporation; and
3. An exchange by the transferor corporation’s shareholders (or shareholders and security holders) of their stock (or stock and securities) of the transferor corporation for stock (or stock and securities) of the acquiring corporation under IRC § 354(a).^[10]

Although the Treasury Department adopted Treas. Reg. § 1.368-2(m) in final form in September 2015,^[11] the rule applies “to transactions occurring on or after January 1, 1985.”^[12] The rule first appeared in proposed and temporary regulations issued in January 1990,^[13] the preamble to which states that the temporary regulations were intended to “clarify” that reorganizations described in IRC § 368(a)(1)(F) include “exchanges under IRC §354(a) and IRC § 361(a).”^[14]

Treas. Reg. § 1.367(a)-1(f) is necessary apply the operative nonrecognition rules provided in IRC §354 and IRC § 361. Any construct that would avoid an IRC § 367 transfer would also avoid an IRC § 361(a) exchange, thereby calling into question the eligibility of the transaction for nonrecognition treatment in the first instance. The parties involved in an outbound F reorganization, however, might have argued that their transaction did not involve any transfers or distributions at all—i.e., the reorganization was a nonevent.^[15] Treas. Reg. § 1.367(a)-1(f) forecloses this argument.

The Parties’ Arguments and Reliance on the Regulations

The IRS argues that Treas. Reg. § 1.367(a)-1(f) establishes the transaction constituted an F reorganization, which included a distribution of TBL GmbH stock by the petitioner to VF Enterprises. The petitioner argues that the IRS is dead ass wrong, and that Treas. Reg. § 1.367(a)-1 applies to IRC § 367(a), not IRC § 367(d) or the IRC § 367(d) Regulations.”

The petitioner’s position rests on Temporary Treas. Reg. § 1.367(a)-1T(a), which (when initially adopted) began as follows:

These regulations set forth rules relating to the provisions of IRC § 367(a) concerning certain transfers of property to foreign corporations. This Temp. Treas. Reg. § 1.367(a)-1T provides general rules explaining the effect of IRC § 367(a)(1) and describing the transfers of property that are subject to the rule of that section.^[16]

When the Treasury Department added Temp. Treas. Reg. § 1.367(a)-1T(f) in 1990, it did not revise paragraph (a).^[17] Therefore, the petitioner reasoned, the rule that now appears in Treas. Reg. § 1.367(a)-1(f), when initially adopted, applied only for the purpose of implementing IRC § 367(a) and had no application to IRC § 367(d). Thus—argueth the petitioner—when the rule was adopted in its current form, the Treasury Department did not indicate an intent to broaden the provision’s scope.

The Tax Court admits that “[f]rom a narrow, technical standpoint, the petitioner’s argument might have some merit.” However, and it’s a big however, “the argument raises difficult questions that the petitioner neither addresses nor even acknowledges.”

Well, crap.

The Treasury Department added Temp. Treas. Reg. § 1.367(a)-1T(f) “to prevent tax avoidance” in outbound F reorganizations.^[18] The preamble to the 1990 amendments did not limit their purpose to preventing the avoidance of IRC § 367(a). The Tax Court could “think of no reason why concerns about tax avoidance in outbound F reorganizations would be limited to those involving tangible property.”

What’s more, as the IRS observes, the petitioner’s argument suggests that its transfer of intangible property was somehow different than its transfer of other property. “The petitioner offers no explanation for why and how an outbound F reorganization would be treated as having been effected by two different and contrary constructs.”

Touché, Tax Court…

And now we get to the zinger:

Even if [the Tax Court] were to leave policy considerations (and perhaps common sense) aside and accept the petitioner’s technical argument that the construct provided in Treas. Reg. § 1.367(a)-1(f) does not apply to the F reorganization in issue, [the Tax Court] would need to identify an alternative construct to explain the transaction. That construct would necessarily include an asset transfer described in IRC § 361(a). (Otherwise, IRC § 367(d) would not apply to the transaction in the first place.)

In such event, the petitioner would be treated as having transferred its intangible property to TBL GmbH in exchange for TBL GmbH stock. However, upon the completion of the transaction, the petitioner no longer owned any TBL GmbH stock and was not, in fact, even recognized as entity for Federal tax purposes. Because of its second entity classification election, the petitioner was disregarded as an entity separate from TBL GmbH.

Upon completion of the transaction, VF Enterprises owned all of the TBL GmbH stock. Therefore, any TBL GmbH stock constructively issued to the petitioner must have found its way—by some means—to VF Enterprises. The circumstances do not allow for treating the petitioner as having received consideration in exchange for the TBL GmbH stock that ended up with VF Enterprises.

It follows that the petitioner’s constructive disposition of that stock “necessarily took the form of a distribution by the petitioner to VF Enterprises in respect of the stock of the petitioner that VF Enterprises was treated as having owned while the petitioner was classified as a corporation.” If that distribution was not in pursuance of the plan of reorganization, and therefore not covered by IRC § 361(c), the petitioner would have recognized gain on the distribution in an amount equal to the gain in the property it constructively transferred to TBL GmbH.^[19]

On balance, the Tax Court found the petitioner’s argument about the scope of Treas. Reg. § 1.367(a)-1(f) “unpersuasive.” In so finding, the Tax Court observed that Treas. Reg. § 1.367(a)-1(a) provides:

IRC § 367(a)(1) provides the general rule concerning transfers of property by a United States person…to a foreign corporation. Paragraph (b) of this section provides general rules explaining the effect of IRC § 367(a)(1). Paragraph (c) of this section describes transfers of property that are described in IRC § 367(a)(1).

Paragraph (d) of this section provides definitions that apply for purposes of IRC §s 367(a) and (d) and the regulations thereunder. Paragraphs (e) and (f) of this section provide rules that apply to certain reorganizations described in IRC § 368(a)(1)(F). Paragraph (g) of this section provides dates of applicability.

Even if the petitioner were correct that Temp. Treas. Reg. § 1.367(a)-1T(f) applied only for the purpose of implementing IRC § 367(a), that temporary provision expired three years after its issuance.^[20] Thus, the transaction is governed by the provision proposed in 1990 and adopted in final form in 2015. The Tax Court, therefore, rejected “any inference that might otherwise be drawn from the failure to amend Temporary Treas. Reg. § 1.367(a)-1T(a)” when Temp. Treas. Reg. § 1.367(a)-1T(f) was initially adopted.

All That to Say, Temp. Treas. Reg. § 1.367(a)-1T(f) Doesn’t Actually Apply

After all of that discussion about Temp. Treas. Reg. § 1.367(a)-1T(f), the Tax Court casually observes that Temp. Treas. Reg. § 1.367(a)-1T(f) doesn’t actually apply to the present transaction.

Way to bury the lede, Judge Halpern…

Instead, the Tax Court characterized the transaction as an F reorganization that involved both a transfer of property described in IRC § 361(a) and a distribution of the stock of the acquiring corporation described in IRC § 361(c). This treatment is appropriate, “regardless of whether Treas. Reg. § 1.367(a)-1(f)” applies or not.

Stage Five: Result of Recharacterization

The Tax Court concluded the transaction was governed by and described in IRC § 368(a)(1)(F). As part of the reorganization, the petitioner is treated as having transferred its intangible and other properties to TBL GmbH in exchange for TBL GmbH stock and as having distributed that TBL GmbH stock to VF Enterprises in cancellation of the stock VF Enterprises had been treated as holding in the petitioner during the time that the petitioner was classified as a corporation for Federal tax purposes.

With all of that having been said, the Tax Court now turned to the question of how IRC § 367(d) applied to those constructive transactions.

Stage Six: Application of IRC § 367(d)

IRC § 367(d)(1) applies, when a U.S. person transfers any intangible property (within the meaning of IRC § 936(h)(3)(B)) to a foreign corporation in an exchange described in IRC § 351 or IRC § 361.^[21] When IRC § 367(d)(1) applies to a transfer, the U.S. person transferring the intangible property is treated as

1. having sold such property in exchange for payments which are contingent upon the productivity, use, or disposition of such property; and
2. receiving amounts which reasonably reflect the amounts which would have been received (i) annually in the form of such payments over the useful life of such property, or (ii) in the case of a disposition following such transfer (whether direct or indirect), at the time of the disposition.^[22]

IRC § 367(d)(2)(C) provides that any amount included in gross income by reason of IRC § 367(d) shall be treated as ordinary income. Further, for purposes of applying IRC § 904(d) (related to the foreign tax credit), any such amount shall be treated in the same manner as if such amount were a royalty. Because the parties agreed that IRC § 367(d) applied to the transaction, the Tax Court reasoned that they must also agree that the petitioner is treated under IRC § 367(d)(2)(A)(i) as having sold its intangible property for one or more contingent payments.

And now we reach the crux of the issue…

The parties’ disagreement centers on when the petitioner should be treated as having received payment and thus when the resulting income should be recognized.

The answer to that question turns on which of the two subclauses of IRC § 367(d)(2)(A)(ii) applies. The IRS argues that subclause (II) applies, with the result that the petitioner recognized all of the income from its deemed sale of intangible property for the taxable year in issue. The petitioner disputes the application of the immediate gain recognition rule provided in that subclause.

Analysis of Transaction under IRC § 367(d)(2)(A): Did a “Disposition” Occur?

To begin with, the Tax Court observed that IRC § 367(d)(2)(a)(ii)(II) applies only in the event of a “disposition following [the] transfer” of intangible property.

The IRS argued that the petitioner’s constructive distribution to VF Enterprises of the stock of TBL GmbH (that it constructively received in exchange for its intangible property) was a “disposition” within the meaning of IRC § 367(d)(2)(a)(ii)(II). Although the petitioner alludes to the prospect that any distribution of TBL GmbH stock deemed to have occurred as part of the reorganization was not a “disposition” within the meaning of IRC § 367(d)(2)(A)(ii)(II), “it does not develop a coherent argument to that effect.”

Halpern burn…

The Tax Court agreed with the IRS and concluded that the petitioner’s constructive distribution to VF Enterprises of the stock of TBL GmbH, the transferee foreign corporation, was a “disposition” within the meaning of IRC § 367(d)(2)(A)(ii)(II).

Analysis of Transaction under IRC § 367(d)(2)(A): Did the Disposition “Follow” the IRC § 367(d) Transfer?

The petitioner accused the IRS of “slic[ing]” the F reorganization “into its component parts…so that there is first a deemed asset transfer of the IP and then there is a separate, subsequent deemed indirect disposition of that same intangible property in the same reorganization transaction.” Relying on the step transaction doctrine, the petitioner asserts that, because any deemed distribution of TBL GmbH stock was—along with the IRC § 367(d) transfer—part of a single reorganization, both steps should be treated as having occurred simultaneously.

The Tax Court was unpersuaded by the petitioner’s step transaction argument:

That the asset transfer and stock distribution were elements of a single overall reorganization does not require treating them as having occurred in precise simultaneity.

As the IRS observed, the petitioner cannot have distributed the stock it received in exchange for its intangible property until it first received that stock. Indeed, the petitioner’s constructive exchange of intangible property for TBL GmbH stock necessarily preceded—if only by a moment—its distribution of that stock to VF Enterprises. The stock distribution might not have “follow[ed]” the transfer of intangible property by much, but, as a matter of logic, it had to follow.

The IRS accepts that the petitioner’s IRC § 361(a) transfer of intangible property and its IRC § 361(c) distribution of the stock it received in exchange for that property occurred as part of an overall reorganization. Indeed, the Tax Court observed, the IRS “is hardly considering the asset transfer and stock distribution separately.” Quite the opposite in fact—the IRS determined the tax consequences of the petitioner’s constructive transfer of intangible property by taking into account the distribution of TBL GmbH stock that occurred as part of the same overall transaction.

The IRS simply recognizes that, “as a logical matter,” the petitioner’s receipt of the TBL GmbH stock in exchange for the transferred intangible property was a precondition to its distribution of that stock to VF Enterprises. The distribution could not have occurred until the exchange of property for stock had been completed. Taking this “logic”
one (logical) step further, the Tax Court sagely observes that:

One cannot distribute what one does not have.

The petitioner also invokes Treas. Reg. § 301.7701-3(g)(3)(i) in support of its claim that the Outbound F Reorganization and its deemed component parts occurred simultaneously. “Again, the petitioner’s argument is flawed in several respects.”

First, the timing rule provided in Treas. Reg. § 301.7701-3(g)(3)(i) applies only to transactions deemed to occur under Treas. Reg. § 301.7701-3(g) itself. Through some circumlocution, the Tax Court concluded that “the petitioner necessarily accepts” that the transactions deemed to occur in the outbound F reorganization are not those described in Treas. Reg. § 301.7701-3(g).

Because the petitioner’s elected to be disregarded, the reorganization is properly described in IRC § 368(a)(1)(F), and the entity classification regulations are superseded by the operative nonrecognition provisions of IRC § 354 and IRC § 361.

Analysis of Transaction under IRC § 367(d)(2)(A): Was the Disposition Within the Property’s Useful Life?

As noted above, under IRC § 367(d)(2)(A)(ii)(II), a “disposition” requires the U.S. transferor of intangible property to recognize gain when it follows the transfer. Although a disposition after the end of the property’s useful life would “follow” the transfer, it would make no sense in that circumstance to require the U.S. transferor to recognize gain under subclause (II) after already having included in income all of the deemed annual payments contemplated by subclause (I).

In recognition of that point, Temp. Treas. Reg. § 1.367(d)-1T(d)(1) requires a U.S. transferor to recognize gain under IRC § 367(d)(2)(A)(ii)(II) upon disposing of stock of the transferee foreign corporation to a person unrelated to the U.S. transferor only if the disposition occurs “within the useful life of the intangible property.”

The petitioner relies on that regulation for “a novel argument” that, even if its distribution of TBL GmbH stock followed its IRC § 367(d) transfer of intangible property, the distribution nonetheless did not require immediate gain recognition because it occurred before the intangible property’s useful life began.

Unfortunately, the Tax Court found that “the authorities the petitioner relies on do not support its argument.”

Ouch.

The petitioner asserts (without citing any authority specific to IRC § 367(d) in support thereof) that “[t]he useful life of property commences when the new owner places the property into service.” The petitioner, instead, drew the court’s attention to a regulation dealing with depreciation allowances for intangible assets. Treas. Reg. § 1.167(a)-3 allows the cost of an intangible asset to be recovered over either 15 or 25 years.

The petitioner draws out its argument as follows:

The reorganization transaction in issue was completed immediately before midnight on September 23, 2011, pursuant to a check-the-box election that was effective on September 24, 2011. Therefore, the earliest that the useful life of the Timberland Intangible Assets could begin with TBL GmbH was Saturday, September 24, 2011. However, since that was a Saturday, the earliest possible placed in service date here would be Monday, September 26, 2011.

The petitioner apparently reasons that, because any distribution it made of TBL GmbH stock to VF Enterprises occurred before September 26, 2011, the distribution did not occur within the useful life of the transferred intangible property and thus cannot have required immediate gain recognition under IRC § 367(d)(2)(A)(ii)(II).

The Tax Court was not buying what the petitioner was selling.

Treas. Reg. § 1.167(a)-3 manifestly has no bearing on the useful life of intangible property for purposes of IRC § 367(d).

Well then…

Treas. Reg. § 1.167(a)-3 is irrelevant to a transferee foreign corporation that received intangible property in an IRC § 367(d) transfer unless that foreign corporation were engaged in a U.S. trade or business or subject to the rules of subpart F (IRC §§ 951-965). Further, Treas. Reg. § 1.167(a)-3 prescribes a general useful life of 15 years—although specified assets are assigned 25-year lives.

By contrast, Temp. Treas. Reg. § 1.367(d)-1T(c)(3) provides that the useful life of intangible property (for IRC § 367 purposes) is the entire period during which the property has value…up to 20 years.

Finally, “[u]nder the plain terms of Treas. Reg. § 1.167(a)-3(b)(3), the useful life of the intangible property in TBL GmbH’s hands would have begun on September 1, 2011—the first day of the month in which TBL GmbH placed the property in service.” Thus, even accepting that the petitioner’s distribution of TBL GmbH stock occurred before the end of the day on September 23, 2011, that distribution would have occurred after the useful life of the intangible property, as defined by Treas. Reg. § 1.167(a)-3(b)(3), had already begun.

The petitioner was hoisted by its own petard, yet again.

Analysis of Transaction under IRC § 367(d)(2)(A): Failure of “No Disposition” Arguments to Explain Reporting

“The petitioner’s various arguments that any “disposition” did not occur within the relevant period share a fundamental problem.” To wit—they fail to explain the tax reporting undertaken in regard to the petitioner’s constructive transfer of intangible property.

Under the terms of the statute, in the absence of a “disposition following [the IRC § 367(d)] transfer,” the annual payments described in IRC § 367(d)(2)(A)(ii)(I) must be reported by the U.S. person transferring such property. The petitioner, then classified as a corporation, was such person. Lee Bell did not transfer the intangible property that TBL GmbH acquired in the F reorganization—indeed, Lee Bell never owned that property.

Analysis of Transaction under IRC § 367(d)(2)(A): Summary of Statutory Application

The petitioner’s constructive distribution to VF Enterprises of the TBL GmbH stock was a “disposition,” within the meaning of IRC § 367(d)(2)(A)(ii)(II), and that the disposition followed the petitioner’s transfer of intangible property to TBL GmbH. Therefore, unless the regulations provide for a different result, the petitioner was required to recognize its gain in the transferred intangible property “at the time of the disposition.”^[23]

Analysis of Transaction under IRC § 367(d)(2)(A): Impact of the Regulations

The Tax Court found nothing in the regulations that would allow the petitioner to avoid immediate gain recognition under IRC § 367(d)(2)(A)(ii)(II). Because the petitioner was no longer recognized as a separate entity for Federal tax purposes after the completion of the F reorganization that included the IRC § 367(d) transfer, it could not report the deemed annual payments described in IRC § 367(d)(2)(A)(ii)(I).

However, no provision in the regulations allows Lee Bell to assume responsibility for reporting those payments, because it was neither the U.S. transferor of the intangible property nor the recipient of the stock of TBL GmbH, the transferee foreign corporation.

Analysis of Transaction under IRC § 367(d)(2)(A): The Petitioner’s Inability to Comply with Temp. Treas. Reg. § 1.367(d)-1T(e)(3)

Temp. Treas. Reg. § 1.367(d)-1T(e)(3), when applicable, allows a U.S. transferor to continue reporting deemed annual payments instead of recognizing immediate gain. Further, the conditions for the application of that rule have been met in the present case.

The petitioner, a U.S. person, did transfer intangible property that is subject to IRC § 367(d) and the rules of Temp. Treas. Reg. § 1.367(d)-1T to TBL GmbH, a foreign corporation, in an exchange described in IRC § 361. Moreover, before the end of the useful life of that property, the petitioner transferred the TBL GmbH stock that it received for the property to VF Enterprises, a foreign person whom the parties seem to accept was “related” to the petitioner within the meaning of Temp. Treas. Reg. § 1.367(d)-1T(h).

Nonetheless, the Tax Court concluded that Temp. Treas. Reg. § 1.367(d)-1T(e)(3) does not apply to the petitioner’s case. The Tax Court reached that conclusion not because of a failure to satisfy the express conditions for the rule’s application but instead “because the rule cannot be applied.”

When applicable, Temp. Treas. Reg. § 1.367(d)-1T(e)(3) requires the U.S. transferor—not some other U.S. person of the taxpayer’s choosing—to continue including in its income the deemed annual payments described in IRC § 367(d)(2)(A)(ii)(I). The petitioner cannot comply with that provision because it is no longer recognized as a separate entity for Federal tax purposes.

By directing a U.S. transferor to “continue to include in its income the deemed payments described in paragraph (c),” Temp. Treas. Reg. § 1.367(d)-1T(e)(3) implicitly requires the U.S. transferor to remain a person with cognizable income. It is that implicit requirement that has not been met in the present case. After the deemed liquidation resulting from its election to be a disregarded entity, the petitioner itself had no income in which to include the deemed annual payments.

Analysis of Transaction under IRC § 367(d)(2)(A): TBL GmbH as Successor to the Petitioner

The petitioner suggests that, under Temp. Treas. Reg. § 1.367(d)-1T(e)(3), TBL GmbH could be allowed or required to include in its income the deemed annual payments described in IRC § 367(d)(2)(A)(ii)(I) because TBL GmbH is the petitioner’s “successor” and, “even more to the point, under the direction of IRC § 368(a)(1)(F), is one in the same entity” as the petitioner. The petitioner contends that it “did not go out of existence” but instead merely “changed form.”

In some reincorporation transactions, the identity between the old and new corporations may be so strong as to allow treating the two as a single corporation.^[24] In those situations, the shareholders’ exchange of stock of the old corporation for that of the new corporation would not be a realization event.

The shareholders would have no need for IRC § 354(a)’s nonrecognition rule. And, in that circumstance, the corporate-level nonrecognition rules provided in IRC § 361 might be unnecessary because no transfer of assets or stock distribution need be imputed. This is not, however, appropriate in this case.^[25] Because TBL GmbH was organized under the laws of Switzerland, it is “essentially different” from a limited liability company organized under the laws of Delaware that is treated as a corporation for Federal tax purposes by reason of the entity’s election.^[26]

Analysis of Transaction under IRC § 367(d)(2)(A): Temp. Treas. Reg. § 1.367(d)-1T(d)(1)

Temp. Treas. Reg. § 1.367(d)-1T(d)(1) does not provide that a U.S. transferor recognizes gain upon a disposition of the stock of the transferee foreign corporation only if that disposition is to an unrelated party. Instead, it says that when the disposition is to an unrelated party, the U.S. transferor must recognize gain. The regulation also, doesn’t technically, say anything about the consequences of a U.S. transferor’s disposition of the stock of the transferee foreign corporation to a related person.

Those dispositions are addressed elsewhere in the regulations–in particular, Temporary Treas. Reg. § 1.367(d)-1T(e)(1) and (3). The prior subparagraph did not even apply to the petitioner’s case, and the petitioner did not (and could not) comply with the mandate of the latter subparagraph.

Analysis of Transaction under IRC § 367(d)(2)(A): Conclusion Part Deux

The Tax Court concluded that the petitioner’s constructive distribution to VF Enterprises of the TBL GmbH stock that the petitioner constructively received in exchange for its intangible property was a “disposition” within the meaning of IRC § 367(d)(2)(A)(ii)(II). The Tax Court also concluded that no provision of the regulations allows the petitioner to avoid the recognition of gain under that statutory provision.

The petitioner suggests that the IRS is to blame for the absence of a provision in the regulations that can be applied to the petitioner’s circumstances. The absence of an applicable regulatory provision, however, requires that the Tax Court look to the statute alone to determine the tax consequences of the petitioner’s transaction. At this point, Judge Halpern observes:

The absence of a provision in the regulations providing otherwise is the petitioner’s problem–not the IRS’s.

That had to sting petitioner’s counsel pretty damn bad…

Because the IRS’s position is grounded in an interpretation of the statute, the Tax Court had a hard time “understand[ing] the petitioner’s argument that the IRS’s ‘litigating position’ is ‘impermissible’” under Bowen v. Georgetown University Hospital.^[27]

Bowen stands for the proposition that an agency’s litigating position is not entitled to the same deference a court would give to a position adopted through notice and comment rulemaking.^[28] There were (at least) two problems with the petitioner’s argument.

First – the IRS was not relying on the regulations. It relied on the statute itself. Second – even if the IRS were relying on the regulations, it did not ask that the Tax Court grant Chevron deference to the interpretation of the applicable statutes that he advances in this case. Because…statutes…

Quickly dismissing this argument and having determined that the petitioner must recognize gain for the taxable year in issue by reason of the application of IRC § 367(d)(2)(A)(ii)(II), the Tax Court now turned to determining the amount of such gain.

Amount of Required Income Inclusion

The parties agree on the amount of income inclusion required under IRC § 367(d)(2)(A)(ii)(II) by reason of the petitioner’s transfer of foreign workforce and foreign customer relationships. They have stipulated that, “[i]f the Court decides that a lump-sum inclusion of income is required under IRC § 367(d)(2)(A)(ii)(II), then the petitioner’s increase in income for the transfer of the foreign workforce and the foreign customer relationships would be $23,400,000 and $174,400,000, respectively.”

The parties agree only in part, however, as to the income inclusion required by reason of the petitioner’s transfer of trademarks. Their stipulation stated:

If the Court decides that a lump-sum inclusion of income is required under IRC § 367(d)(2)(A)(ii)(II), then The petitioner’s increase in income for the transfer of the trademarks is $1,274,100,000, unless the Court agrees to reduce the adjustment to income for the trademarks based on a 20-year useful life limitation, pursuant to Temp. Treas. Reg. § 1.367(d)-1T, in which case the increase in income for the transfer of the trademarks is $1,029,200,000, in each case less the reported trademark basis of $19,339,000.

Thus, the parties apparently agree that the income inclusion required by IRC § 367(d)(2)(A)(ii)(II) is the excess of the fair market value of the transferred intangible property at the time of the petitioner’s disposition of the TBL GmbH stock over the basis of that property.^[29]

They also agree on the values of the foreign workforce and customer relationships that the petitioner constructively transferred to TBL GmbH and on the petitioner’s tax basis in the transferred property. Finally, they agree on the resolution of the factual question of the trademarks’ value under two alternative legal assumptions.

Their point of disagreement is whether, as a matter of law, the fair market value of the trademarks must be determined by treating each as having a useful life of no more than 20 years. That legal question, which the petitioner raised in an amendment to its petition, arises by reason of Temporary Treas. Reg. § 1.367(d)-1T(c)(3).

This regulation, as in effect for 2011, provided that “[f]or purposes of this section, the useful life of intangible property is the entire period during which the property has value. However, in no event shall the useful life of an item of intangible property be considered to exceed twenty years.”

The petitioner argued that if the Tax Court determined that a subsequent transfer occurred resulting in a lump-sum inclusion amount, Temp. Treas. Reg. § 1.367(d)-1T(c)(3) “requires that the inclusion be calculated with a 20-year useful life limitation.” The IRS countered that IRC § 367(d)(2)(A)(ii)(II) makes no reference whatsoever to the “useful life” of the transferred property.”

Instead, the IRS characterizes Temp. Treas. Reg. § 1.367(d)-1T(c)(3) as a “regulatory grace applicable to the annual inclusion paradigm.” According to the IRS, the petitioner cannot rely on an administrative limitation on the time period over which annual inclusions would be taken into account for purposes of reducing its disposition rule amount. The 20-year regulatory limitation on the annual inclusion period is not a substitute methodology overriding settled law concerning the definition of fair market value.

In this regard, the IRS points to Temp. Treas. Reg. § 1.367(d)-1T(g)(5), which provides that

For purposes of determining the gain to be recognized immediately under paragraph (d), (f), or (g)(2) of this section, the fair market value of transferred property shall be the single payment arm’s-length price that would be paid for the property by an unrelated purchaser determined in accordance with the principles of IRC § 482 and regulations thereunder.

The IRS suggests that imposing an “artificial limitation” on the value of transferred intangible property would frustrate Congress’ purpose in enacting IRC § 367(d). The IRS argued that because the limitation on useful life in Temp. Treas. Reg. § 1.367(d)-1T(c)(3) could “only have the effect of reducing the amount that would be taxed pursuant to Congress’s intentions under IRC § 367(d).

Thus, the limitation should be read narrowly and applied only to the circumstances specified in the regulations, i.e., annual inclusions and the time frame within which the intangible property must be transferred to trigger” IRC § 367(d)(2)(A)(ii)(II).

The petitioner countered that Temp. Treas. Reg. § 1.367(d)-1T(c)(3) does not state that it only applies to annual IRC § 367(d) payments. Instead, Temp. Treas. Reg. § 1.367(d)-1T(c)(3) provided that it applied “for purposes of this section.” The petitioner further noted that a property’s useful life is a relevant factor in determining its fair market value and insists that “the regulations require a 20-year time frame for all useful life analyses.”

At this point, it should be noted that the Tax Court does not pick on the petitioner alone. Instead, it dismisses both the petitioner’s and the IRS’s reliance on Temp.^[30]

The Tax Court concluded that the petitioner must recognize gain as a result of its constructive transfer of intangible property to TBL GmbH. This conclusion, however, did not “rest on any provision in Temp. Treas. Reg. § 1.367(d)-1T.” The only rule in that section of the regulations that requires the recognition of gain upon a disposition of stock of the transferee foreign corporation— Temp. Treas. Reg. § 1.367(d)-1T(d)(1)—applies when that disposition is to a person unrelated to the U.S. transferor.

The Tax Court accepted the parties’ “apparent view” that VF Enterprises was related to the petitioner within the meaning of Temp. Treas. Reg. § 1.367(d)-1T(h). Consequently, Temp. Treas. Reg. § 1.367(d)-1T(d)(1) is not the basis for the Tax Court’s conclusion that the petitioner must recognize gain in the transferred intangible property as a result of its constructive distribution to VF Enterprises of TBL GmbH stock. Instead, the Tax Court’s conclusion rests on the statutory gain recognition rule provided in IRC § 367(d)(2)(A)(ii)(II).

The implication that the useful life limitation imposed by Temp. Treas. Reg. § 1.367(d)-1T(c)(3) might apply in determining the amount of gain that must be recognized under paragraph Temp. Treas. Reg. § 1.367(d)-1T(d)(1) would conflict with the definition of “fair market value” provided in paragraph Temp. Treas. Reg. § 1.367(d)-1T(g)(5). As the IRS observed, Temp. Treas. Reg. § 1.367(d)-1T(g)(5) provides that the fair market value of transferred property is the amount that an unrelated purchaser would pay for the property.

This regulation expressly applies “[f]or purposes of determining the gain…recognized immediately under paragraph (d), (f), or (g)(2)” of Temp. Treas. Reg. § 1.367(d)-1T. Thus, in an arm’s-length transaction, an unrelated purchaser of intangible property would consider the entire period during which the property would have value in determining the price it would pay for the property.

The terms of paragraph Temp. Treas. Reg. § 1.367(d)-1T(g)(5), which specifically and expressly govern the determination of the fair market value of intangible property for the purpose of determining gain that must be recognized under an immediate gain recognition rule “must take precedence over possible implications of a more general provision regarding the property’s useful life.” As the petitioner recognizes, specific regulations govern over general regulations.

The petitioner admits that $1,029,200,000 is not “the full fair market value” of the trademarks it constructively transferred to TBL GmbH. The petitioner acknowledges that the values it reported on its Form 926, including the $1,274,100,000 value assigned to the trademarks, were the fair market values of the Timberland Intangible Assets without the application of the regulations’ useful life limitation. The petitioner reported those amounts, it explained, because “Form 926 states that the full fair market value be stated on the form.”

The petitioner offers us no explanation for why the drafters of Temp. Treas. Reg. § 1.367(d)-1T might have intended that the amount of gain a U.S. transferor is required to recognize upon a direct or indirect disposition of transferred intangible property should be computed on the basis of a value that is less than the property’s “full fair market value.” Allowing a U.S. transferor to avoid recognizing the full amount of gain in the transferred intangible property has—according to the Tax Court—”no apparent justification.”

Therefore, the Tax Court declined to apply Temp. Treas. Reg. § 1.367(d)-1T(c)(3) “beyond the purposes for which it was expressly relevant” (which is to say, for purposes of applying other provisions of the regulations that explicitly refer to the intangible property’s “useful life”). By reason of Temp. Treas. Reg. § 1.367(d)-1T(g)(5), the gain that a U.S. transferor must recognize under Temp. Treas. Reg. § 1.367(d)-1T(d)(1) upon disposing of the stock of the transferee foreign corporation to an unrelated person should take into account the actual fair market value of the transferred intangible property on the date of the disposition.

Such fair market value should reflect the amount that an unrelated purchaser would pay for the property in an arm’s-length transaction, taking into account the entire period during which the property may be expected to have value.

Because the Tax Court did not “agree” to reduce the adjustment to income for the trademarks based on a 20-year useful life limitation, under Temp. Treas. Reg. § 1.367(d)-1T, as the petitioner cordially requested, the Tax Court determined that the petitioner’s increase in income for the transfer of the trademarks is $1,274,100,000.

That would be bad enough, but the Tax Court was not quite done yet…

Adding that figure to the agreed value of the foreign workforce and customer relationships that the petitioner transferred to TBL GmbH and reducing the sum by the agreed trademark basis, the Tax Court concluded that the petitioner’s income for the taxable year in issue should be increased by $1,452,561,000.^[31]

That, dear readers, is a bad day in the Tax Court.

(158 T.C. No. 1) The Timberland Company v. Commissioner

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Footnotes:

1. See Treas. Reg. § 301.7701-3(b)(1)(ii). ↑
2. See Treas. Reg. § 301.7701-2(b)(2). ↑
3. Treas. Reg. § 301.7701-3(c)(1)(iv). ↑
4. Id. ↑
5. Treas. Reg. § 301.7701-3(g)(1)(iii). ↑
6. Treas. Reg. § 1.368-2(m). ↑
7. Treas. Reg. § 1.368-2(m)(5). ↑
8. Berghash v. Commissioner, 43 T.C. 743, 752 (1965) (footnote omitted), aff’d, 361 F.2d 257 (2d Cir. 1966). ↑
9. Id. ↑
10. Treas. Reg. § 1.367(a)-1(f)(1). ↑
11. T.D. 9739. ↑
12. Treas. Reg. § 1.367(a)-1(g)(4). ↑
13. T.D. 8280. ↑
14. Id. at 80. ↑
15. See, e.g., Berghash, 43 T.C. at 752. ↑
16. T.D. 8087. ↑
17. T.D. 8280. ↑
18. Id. ↑
19. See IRC § 311(b) (requiring recognition of gain on distributions by a corporation of appreciated property); IRC § 358(a)(1) (providing as a general rule that the basis of nonrecognition property received in an IRC § 361 exchange equals the basis of the property exchanged). ↑
20. See IRC § 7805(e)(2). ↑
21. IRC § 367(d)(1). ↑
22. IRC § 367(d)(2)(A). ↑
23. IRC § 367(d)(2)(A)(ii)(II). ↑
24. See, e.g., Weiss v. Stearn, 265 U.S. 242 (1924) (holding that, in reincorporation in which both corporations were organized under the laws of the same State, participating shareholders realized gain only to the extent of the cash they received). ↑
25. See, e.g., Marr v. United States, 268 U.S. 536, 536 (1925); United States v. Phellis, 257 U.S. 156, 156 (1921). ↑
26. See Marr, 268 U.S. at 541. ↑
27. 488 U.S. 204 (1988) ↑
28. See Id. at 212-13; see also Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837, 842-43 (1984). ↑
29. Cf. Temp. Treas. Reg. § 1.367(d)-1T(d)(1). ↑
30. Treas. Reg. § 1.367(d)-1T(c)(3). ↑
31. $1,274,100,000 + $23,400,000 + $174,400,000 − $19,339,000 = $1,452,561,000 ↑

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