Valuation Implications of ProposedGoodwill Regulations

By Ken Brewer and Philip Antoon

Reprinted from Tax Notes, February 22, 2016, p. 913

tax notesVolume 150, Number 8 February 22, 2016

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Valuation Implications ofProposed Goodwill Regulations

By Ken Brewer and Philip Antoon

On September 14, 2015, Treasury and the IRSreleased proposed regulations under section 367that would dramatically change the treatment ofgoodwill and going concern value transferred by aU.S. person to a foreign corporation in what, in apurely domestic context, would otherwise be atax-free transaction.1 If finalized as proposed, theregulations would be effective retroactively fortransfers occurring on or after September 14, 2015.Several commentators, including two of the BigFour public accounting firms, submitted commentsbefore the December 15, 2015, deadline.

The following summarizes the proposed regula-tions and notes some potential changes in the waycompanies might approach the allocation of valueamong the transferred assets.

Under existing section 367 regulations, the trans-fer of goodwill and going concern value to a foreigncorporation can qualify for nonrecognition of gain

or loss if they are transferred for use in the activeconduct of a trade or business outside the UnitedStates. Under the proposed regulations, these trans-fers would no longer qualify for nonrecognition ofgain.

The proposed change reflects the Obama admin-istration’s views on the proper policies for section367 but is contrary to the policy views of Congress,as expressed in the section’s legislative history.Because of this conflict with legislative intent, thereis reason to believe that if the regulations arefinalized as proposed, they may be found invalid ifchallenged in court (that is, under a Chevron analy-sis). Several of the comment letters, including thosesubmitted by Deloitte Tax LLP and PwC, reflect thatview and strongly recommend that the proposedregulations be revised, or withdrawn and reissued,to include rules consistent with the legislative in-tent.

The proposed regulations present difficultchoices for taxpayers currently considering the in-corporation of foreign operations that are nowconducted in passthrough (that is, branch or part-nership) format, and they may change the calculusfor taxpayers contemplating the choice of entity forstart-up operations outside the United States. Tax-payers making business, tax, and valuation deci-sions now in reliance on the proposed regulationsmay eventually find that the regulations, includingtheir proposed effective date, have substantiallychanged by the time they are issued in final form —in ways that might have led to different decisions.Hopefully the final regulations will permit taxpay-ers to retroactively change any of these decisions,when appropriate. However, it is unlikely that thefinal regulations would permit a retroactive changein appraised values arrived at by taxpayers thatacted in reliance on the proposed regulations.

By way of background, U.S. tax law containsnonrecognition rules that generally permit the tax-free transfer of property to a corporation in connec-tion with the corporation’s formation orreorganization. Section 367 provides a set of rulesthat override nonrecognition treatment, to someextent, when the transferor is a U.S. person and thetransferee is a foreign corporation (so-called out-bound transfers).

Ever since its enactment in 1976, section 367 hasbeen interpreted to permit the tax-free transfer ofgoodwill and going concern value to a foreigncorporation for use in the active conduct of a trade1REG-139483-13.

Philip Antoon

Ken Brewer

Ken Brewer is an interna-tional tax practitioner and asenior adviser with Alvarez &Marsal Taxand. Philip Antoonis a managing director with Al-varez & Marsal Taxand, spe-cializing in valuations ofentities and intangible assetsfor tax purposes.

In this article, Brewer andAntoon discuss recently pro-posed regulations under section367 that would dramaticallychange the treatment of good-will and going concern valuetransferred by a U.S. person to aforeign corporation.

Copyright 2016 Ken Brewer and Philip Antoon.All rights reserved.

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or business outside the United States. The Obamaadministration has made it known that it disagreeswith the policy views of Congress, as expressed inthe legislative history to section 367, regarding thefavorable treatment of goodwill and going concernvalue. The administration’s budget proposals haveconsistently called for the elimination of that favor-able treatment, citing it as a source of abuse of theU.S. tax system. Apparently unwilling to wait anylonger for Congress to act, the administration hastaken it upon itself to make this change by means ofa regulation.

Under the proposed regulations, taxpayerswould have two options for the treatment of out-bound transfers of goodwill and going concernvalue. The following is a discussion of those optionsand the potential valuation implications:

The first alternative is to opt for immediaterecognition of gain under section 367(a).

Under this option, any gain inherent in good-will and going concern value would be recog-nized at the time of the transfer. The transfer ofany other types of intangibles would remaintaxable under the deferred, contingent saletreatment provided by section 367(d). Giventhe resulting difference in the treatment ofgoodwill and going concern value, as com-pared with the treatment of other intangibles,option one would require a separate valuationof each element of intangible value and sepa-rate determinations of the useful lives of eachelement. To the extent that value is allocated togoodwill and going concern value, incomerecognition would be accelerated to the year ofthe transfer. This may be undesirable in mostinstances, but it may be desirable for taxpayersthat wish to accelerate income (for example, toavoid the expiration of net operating losses ortax credit carryovers).

Because goodwill is a residual asset — that is,it reflects the difference between the overallvalue of the company less the value of thetangible and identifiable intangible assets — itis not valued discretely. The first step in valu-ing goodwill is to estimate the value of theoverall entity. Once the overall entity value isdetermined, the values of the tangible andidentifiable intangible assets are then de-ducted to derive the residual value consistingof goodwill.

In valuing the overall entity, it is important toproceed cautiously because there are manysubtleties associated with conducting a valua-tion for U.S. tax purposes relative to otherpurposes (such as financial reporting pur-poses). Rather than providing a tutorial on

valuing a business, we instead highlight thekey issues that — unlike many other types ofvaluations — must be considered in a valua-tion conducted for tax purposes. These are:

• treatment of intercompany transactions;• nature of the entity;• transfer pricing and profit margin;• entity risk;• intellectual property ownership; and• repatriation position and tax rates.

Each of the above factors can have a significanteffect on the appraised value of an entity.Failure to properly address any of them canadversely affect the validity of the appraisal. Itis worth noting that we are often asked if usingthe net book value of the entity as a proxy forthe fair market value is a reasonable assump-tion. The answer is typically no, because thenet book value provides an accounting figureand thus in most cases understates the value ofthe entity, given that it does not capture thefull (or in some cases any of the) value ofintangible assets, including goodwill and go-ing concern.

The values of the so-called identifiable intan-gible assets that were previously derived forthe calculation of the goodwill value couldalso potentially be used to compute earningsand profits of the transferee corporation forperiods after the outbound transfer. In thisscenario, the approach to ascribing an arm’s-length value to the intangibles could varydepending on the circumstances. Given thatgoodwill and going concern will typicallycarry different lives than the identifiable intan-gible assets and considering (as detailed be-low) that the proposed regulations would alsoeliminate a rule in the existing regulations thatlimits the useful life of intangible property to20 years for purposes of section 367(d), regard-less of the approach taken, the valuation of theindividual assets is likely to create additionalcomplexity.

A second alternative is to treat goodwill andgoing concern value as being subject to therules for intangible property covered in section367(d). Under section 367(d), a U.S. taxpayerthat contributes intangible property to a for-eign corporation is treated as though it soldthe intangible to the foreign corporation for astream of contingent payments over the usefullife of the intangible, with the hypotheticalcontingent amounts being ‘‘commensuratewith the income attributable to the intan-gible.’’

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‘‘Commensurate with income’’ determinationsmay involve varying methods, one of whichcould be FMV. There are numerous variablesand outcomes that affect the commensuratewith income measurement, a key questionbeing the most appropriate method for ascrib-ing value to goodwill, given its unique char-acteristics relative to identifiable intangibleassets (that is, the inability to discretely valuegoodwill, the potential for an indefinite life,and so on). Other considerations include thelife ascribed to each transferred asset, themethod applied to ascribe value, etc.

In addition to requiring gain recognition onoutbound transfers of goodwill and goingconcern value, the proposed regulationswould eliminate a rule in the existing regula-tions that limits the useful life of intangibleproperty to 20 years for purposes of section367(d). As a result of that change, the hypo-thetical contingent payments created by sec-tion 367(d) would continue for the entireperiod during which the exploitation of theintangible property was reasonably antici-pated to occur, as of the time of the outboundtransfer (which could be far longer than 20years).

These proposed regulations came shortly afterNotice 2015-54,2 issued on August 6, 2015, indicat-ing that Treasury and the IRS will be issuingregulations, based on similar policy concerns, thatwill reduce the possibilities for nonrecognitiontreatment of transfers of property to partnershipsthat have foreign partners.3

Taxpayers contemplating a transfer of businessoperations to a foreign corporation (either an actualtransfer or a deemed transfer resulting from anentity classification election) will need to make adecision as to the likelihood that the proposedregulations will be finalized in their present formand, if so, whether they are likely to withstand acourt challenge. For public companies, this may bea particularly difficult issue to address for purposesof Financial Accounting Standards Board Interpre-tation No. 48 and any required disclosures in theSchedules UTP.

Assuming that the proposed regulations are fi-nalized in their present form (and remain in effect),they may make it undesirable to transfer operationsto a foreign corporation. Alternatively, if the tax-payer decides to proceed with an outbound trans-fer, it will need to decide whether to electimmediate gain recognition under section 367(a) ordeferred/periodic gain recognition under section367(d) for goodwill and going concern value. Formany taxpayers, the latter choice is likely to bemore desirable. But for some, (for example, thosethat may have expiring tax credits), the alternativeof immediate gain recognition may represent a taxplanning opportunity.

To make an informed decision whether to trans-fer operations to a foreign corporation and whetherto elect immediate or deferred/periodic gain recog-nition for goodwill and going concern value, itwould be prudent to model out the projected after-tax consequences of those decisions. A key aspect inmaking an informed decision will be the valueascribed to goodwill, which will carry significantcomplexity.

For new foreign operations, the proposed regu-lations will tend to make it more desirable tooperate through a foreign corporation from incep-tion, rather than operating through a branch of aU.S. corporation for some period with the possibil-ity of incorporating a foreign subsidiary later.

2Notice 2015-54, 2015-34 IRB 210.3See Jill-Marie Harding, ‘‘And Then There Were Two . . . One

Less Way to Efficiently Migrate IP Offshore — the Impact ofNotice 2015-54 on IP Partnerships,’’ Alvarez & Marsal TaxandTax Advisor Weekly (Sept. 29, 2015).

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