Online Tax Advisor Q&A:
US tax implications of receiving voting stock in exchange for services and know-how
From Ernst & Young Online Tax Advisor. Copyright Ernst & Young.
Submitted By:a major US manufacturer
Subject:US tax implications of receiving voting stock in exchange for services and know-how
Facts:
Several parties are getting together to form a Cayman Islands corporation (FCorp). There are two types of investors - US individuals (USSH), and foreign investment fund (FIF).
FCorp will authorize and issue two classes of voting stock. Class A will be issued to USSH; Class B will be issued to FIF. Class A shareholders will be able to elect two directors to the board. Class B shareholders will be able to elect its own two directors. Shareholders of both classes will then vote on the fifth director. Class A stock will represent 54% voting of all classes of stock; Class B stock will represent 46%.
USSH will invest a small amount of capital, and they will contribute services and know-how in exchange for Class A stock (representing 54% voting interest of all classes).
FIF will invest capital in exchange for Class B stock (representing 46%).
IRC §351(a) generally provides tax-free incorporation/capital contribution. However, in this case, USSH will contribute services and know-how.
Question:
What are the US tax implications of receiving voting stock/options in exchange for services and know-how?
Conclusion:
Services are not treated as property for purposes of IRC §351. To the extent a taxpayer contributes services to a corporation in exchange for stock, he will generally recognize compensation income upon the transfer. IRC §351(d)(1).
Since we do not have information on the type of know-how at issue, it is difficult to determine if the transfer in exchange for stock qualifies as property under IRC §351. However, if all substantial rights in the know-how are transferred, and it was not created specifically for FCorp, then it should probably be considered property for IRC §351 purposes.
Analysis:
Under IRC §351, generally, no gain or loss is recognized by transferors of property to a corporation solely in exchange for stock of the corporation, if immediately after the exchange, the transferors are in control of the transferee corporation. Control for these purposes is defined as the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock.
Assuming all other requirements of IRC §351 are met (i.e., control and solely in exchange for stock), the issue presented is to explain the treatment of services and know-how under IRC§ 351. IRC §351 affords nonrecognition treatment as long as property is contributed to the corporation. Services are not considered property. To the extent a taxpayer contributes services to a corporation in exchange for stock, he will generally recognize compensation income upon the transfer. IRC §351(d)(1) and 83.
There is no clear statutory or regulatory definition of what constitutes property for purposes of IRC §351, apart from three specific statutory exclusions relating to services, certain indebtedness, and accrued interest on certain indebtedness. While the absence of a clear definition is not usually problematic, the issue of whether intangibles such as technical know-how qualify as §351 property has not been clearly resolved.
Case law provides a broad definition of property for purposes of IRC §351. As a general rule, the courts have found that anything that has value, is legally owned, and can be transferred constitutes property. For example, in the landmark case of E.I. Du Pont de Nemours & Company v. United States, 471 F.2d 1211 (Ct. Cl. 1973), the IRS claimed that a grant of nonexclusive licenses to use certain patents did not qualify as a transfer of property under IRC §351 because the taxpayer did not transfer substantially all the rights to the patents. The Court of Claims rejected the IRS' contention that a transfer of "substantially all the rights" to property is a prerequisite to qualifying under IRC §351, and held that the grant of the licenses qualified as a transfer of property under IRC §351 because the licenses had substantial value.
The IRS provides limited guidance regarding when intangibles qualify as property under IRC §351. As for transfers of intangible property not evidenced by documentation, such as trade secrets and technical know-how, Revenue Ruling 64-56 (1964-1 CB 133) indicates that "property" for §351 purposes includes "secret information as to a device, process, etc., in the general nature of a patentable invention without regard to whether a patent has been applied for and without regard to whether it is patentable in the patent law sense." Again, the transfer of all substantial rights in the property will be treated as a transfer of property for purposes of §351. However, the IRS does state that the transfer of know-how will not qualify if "the information transferred has been developed specially for the transferee," in which case the stock may be treated as received for services.
To determine if property has been transferred, Rev. Rul. 64-56 also provides that services that are ancillary and subsidiary to the transfer of property are disregarded and do not cause the transfer to be taxable. In the event that services are not considered ancillary or subsidiary, a reasonable allocation of the value of the stock received by the transferor is made between the separate elements of consideration provided (i.e., the transferred property and the services provided).
Rev. Proc. 69-19, 1969-2 C.B. 301 provides additional guidance and sets forth the circumstances under which the IRS will issue a private letter ruling that a transfer of "know-how" in exchange for stock will qualify under IRC §351. Pursuant to Rev. Proc. 69-19, the taxpayer is required to state that the information to be transferred is secret in that it is known only by the owner and those confidential employees who require the information for use in the conduct of the activities to which it is related, adequate safeguards have been taken to guard the secret against unauthorized disclosure, and the information represents a discovery and, while not necessarily patentable, is original, unique and novel.
Given the limited information provided about the know-how at issue, it is difficult to determine if it will qualify as property under IRC §351. However, it seems likely that the know-how will constitute property if it was not created specifically for FCorp, and substantially all of the rights to the property are treated as transferred.
Comments:
We have not analyzed potential international tax consequences of the transaction. Also, a person receiving stock for services cannot be counted in determining whether the transferors of property are in control of the transferee corporation immediately after the exchange.
Prepared by: Jim Warner and Valerie Williams
Jim heads up the Online Tax Advisor's Mergers & Acquisitions specialty area. He graduated from the LLM in Taxation program at Georgetown University. He was the attorney-advisor for the Tax Court and the IRS' Office of Chief Counsel. Prior to joining Ernst & Young, he was a partner with Lee, Toomey, and Kent, a tax specialty firm in Washington, DC.
Valerie is a senior manager who has specialized in the mergers and acquisitions area for seven years. She is a CPA and earned her Masters in Taxation degree from the University of Alabama.
Posted 9/03