International JVs Feb 2010

INTERNATIONAL JOINT VENTURES
by
DAVID L. FORST
FENWICK & WEST LLP
WWW.FENWICK.COM
FEBRUARY 2010
INTERNATIONAL JOINT VENTURES

TABLE OF CONTENTS
I. II. III. Introduction .............................................................................................................1 Consequences of Entity Classification ...................................................................1 U.S. Partner in a Foreign Partnership .....................................................................2 A. General Structuring Considerations ...........................................................2 B. The Partnership Agreement ........................................................................3 C. Partnership Elections ..................................................................................5 D. Partnership Returns .....................................................................................7 E. Transfer of Assets to a Foreign Partnership ................................................8 F. Section 704(c) Issues ..................................................................................12 G. Dual Consolidated Loss Issue ( 1503(d))..................................................16 H. Section 987 Currency Rules........................................................................25 I. Foreign Taxes..............................................................................................32 J. Allocation and Apportionment of Expenses ...............................................51 K. Challenges to Partnership Allocations ........................................................55 L. Section 752 Regulations on Disregarded Entities .......................................56 M. Sale of CFC by Foreign Partnership-Section 1248 .....................................59 N. Section 894..................................................................................................60 O. Exit Strategies .............................................................................................61 Partnership with U.S. and Foreign Partners Conducting Business Inside the U.S. .....................................................................................................................63 A. In General....................................................................................................63 B. Section 1446 Withholding ..........................................................................64 C. Foreign Partners Filing U.S. Federal Income Tax Return ..........................68 D. Sale or Exchange of Partnership Interest ....................................................69 Partnerships with a Foreign Subsidiary as a Partner ...............................................69 A. Overview .....................................................................................................69 B. Aggregate-Entity-Conduit Treatment .........................................................70 C. Background of Anti-Brown Group Regulations .........................................71 D. Foreign Personal Holding Company Income ..............................................73 E. Foreign Base Company Sales Income ........................................................77 F. Foreign Base Company Services Income ...................................................88 G. Notice 2009-7..............................................................................................88 H. Section 956..................................................................................................89 I. Subpart F Deductions and Losses ...............................................................93 J. Section 987..................................................................................................93 K. Exit Issues ...................................................................................................94
IV.
V.
I.
INTRODUCTION This outline discusses the principal federal income tax issues that arise, when a U.S. corporation establishes a joint venture outside the U.S. with a foreign joint venturer using a non-U.S. entity treated as a partnership for U.S. federal income tax purposes. It also discusses certain issues when a U.S. corporation is a partner with one or more foreign partners in a domestic joint venture and where a controlled foreign corporation (CFC) is a partner in a foreign entity treated as a partnership for U.S. federal income tax purposes.
II.
CONSEQUENCES OF ENTITY CLASSIFICATION Among the U.S. tax issues which depend on whether the foreign entity constitutes a branch, a partnership or a corporation for U.S. tax purposes are: A. B. The taxation of contributions of property, including intangibles, by a U.S. person to the foreign entity. See 367, 351 and 721. The flow-through of early tax losses and subsequent taxable income to the owners if the entity is a partnership or branch 704(b), (c) and (d); together with possible application of the dual consolidated loss rules of 1503(d); the branch loss recapture rules of 367(a)(3)(C), and the overall foreign loss rules of 904(f). Possible deferral of U.S. tax on the entitys profits if the entity is a corporation. Application of the U.S. Subpart F and PFIC rules depends on whether the entity is a corporation or a partnership. See, e.g., Treas. Reg. 1.952-1(g) (the anti-Brown Group regulations) The effective application of 482. The nature (direct or indirect), availability and calculation of foreign tax credits; Tax consequences of current distributions. See 731, 987, 301. Tax consequences of a disposition or liquidation of the entity. See 731, 331, 332, 336, 337, 367(b), 1248. Tax consequences of certain taxable acquisitions. See 338 and 754/743. Application of foreign currency rules of 985-989.
C. D.
E. F. G. H. I. J.
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K.
Application of U.S. withholding tax rules. 1441-1446. Note in particular a partnerships obligation to withhold on the distributive share of its foreign partners U.S. effectively connected income. 1446. Reporting requirements. Forms 5471 and 8865; 6038, 6038B, 6046A, and 6031(e).
L. III.
U.S. PARTNER IN A FOREIGN PARTNERSHIP A. General Structuring Considerations 1. This structure would involve either a U.S. person investing directly in a foreign partnership or a U.S. person investing directly in a foreign limited company that makes a check-the-box election to be treated as a partnership. It also could involve a U.S. person holding a foreign partnership interest through a foreign entity that makes a check-the-box election to be treated as fiscally transparent. U.S. partners could find this structure attractive for a number of reasons (a) (b) Losses flow through into the U.S. return. Foreign tax credits flow through to the U.S. return. The flow through of credits might be particularly important if the joint venture entity or a foreign holding company were treated as a corporation and could not remit a dividend due to a lack of earnings and profits. A partnership permits much more flexibility in how the partners structure their business deal. For example, the partners can specially allocate tax items, including deductions and credits. This is not possible in a corporate structure. See Treas. Reg. 1.902-1(a)(9)(iv) and (10)(ii) (forbidding the special allocation of earnings and taxes to particular shareholders). It is easier to transfer property to a foreign partnership, as the 367 outbound transfer rules do not apply. In particular 367(d) does not apply to the transfer of intellectual property to a foreign partnership. Further, if the partnership pays the transferor-partner a royalty, the partnerships royalty deduction could be specially allocated to the transferor-partner.
2.
(c)
(d)
(e)
The distribution of property from a partnership to a partner generally is tax free, the principal exception being if the amount of cash or cash equivalents distributed to a partner exceeds the partners adjusted basis in its partnership interest. 731(a)(1). The liquidation of a partnership generally is tax free, again the principal exception being if the amount of cash or cash equivalents distributed to a partner exceeds that partners basis in its partnership interest. 731(a)(1). It is generally less tax costly to convert a partnership to a corporation than vice versa. In the international context, due consideration must be given to 367 issues on an incorporation, for example the branch loss recapture rule if the partnership incurred losses that flowed through to the U.S. return (Treas. Reg. 1.367(a)-6T), and the outbound transfer of intangibles ( 367(d)).
(f)
(g)
3.
A tax planner obviously will need to take into account countervailing considerations, such as income of the joint venture flowing through to the U.S. return, deductions that flow through being characterized as foreign source deductions, the dual consolidated loss rules ( 1503), the overall foreign loss rules ( 904(f)), 987 currency issues, and limitation on deduction of partnership losses ( 704(d)). A U.S. taxpayer who desires to defer the foreign joint ventures income from U.S. tax but also conduct the joint venture in partnership form either could make a reverse check-the-box election in respect of the joint venture entity (to cause the joint venture entity to be treated as a corporation for U.S. tax purposes) or form a foreign holding company to hold the joint venture interest (with due consideration to subpart F and other anti-deferral provisions).
4.
B.
The Partnership Agreement 1. If the partnerships business is conducted principally outside the U.S., the partnership likely will be an entity organized under a foreign jurisdiction. The U.S. members need to pay careful attention to what will constitute the partnership agreement. The regulations define a partnership agreement broadly as the original agreement among the
2.
partners, whether oral or written, and any modifications thereof. Treas. Reg. 1.761-1(c). See also Treas. Reg. 1.704 1(b)(2)(ii)(h). 3. If the joint venture entity is treated as a corporation under foreign law, then its organizational document typically will be its articles of association, bylaws or the equivalent. Such documents are not partnership agreements in the traditional sense and will lack many of the provisions that might be desired by the U.S. partners or might be required by U.S. tax rules. Even if the joint venture entity is treated as a partnership under foreign law, issues that are unique to the U.S. tax rules would need to be addressed. These issues should be addressed up-front, before the transaction documents are executed. If a matter is not addressed in the partnership agreement, then the regulations state that provisions of local law are considered to constitute part of the agreement. The U.S. partners will want to thoroughly familiarize themselves with foreign law to the extent that the partnership agreement is silent on any issues that may be important to them. A safer approach generally is to address all important issues in the partnership agreement itself. One issue in particular that U.S. partners will want to consider is whether it is necessary or desirable for the partners to have 704(b) capital accounts and for the partnership agreement to include capital account maintenance provisions. (a) Complying with the capital account maintenance provisions provides certainty as to the validity of partnership tax allocations. However, 704(b) capital accounts, which are maintained under U.S. tax rules, can add layers of complication to a deal whose economics are reflected through the prism of foreign tax and accounting rules. Further, foreign partners, and particularly those without U.S. tax counsel, might balk at the partnership agreements inclusion of an unfamiliar and complex set of rules. Thus, U.S. partners should consider whether the maintenance of capital accounts is necessary or whether it is safe to fall back on the general and more administrable
4.
5.
6.
(b)
(c)
partners interest in the partnership test as the means of governing partnership allocations. See Treas. Reg. 1.7041(b)(3). In particular, it is important to think through whether there could be mismatches between allocations and distributions that are mandated by foreign rules and those that are mandated by U.S. rules. Any such issues should be addressed before the partnership agreement is signed and not before tax returns are filed. 7. There are many other provisions that U.S. partners might want to consider adding to the partnership agreement, including provisions governingdistributions, including tax liability distributions and liquidating distributions; special allocations of income or loss; the selection of 704(c) methods; how tax controversies are handled; and matters in respect of the transfer of partnership interests (such as whether the partnership closes its books immediately before the transfer or pro rates its income in the year of the transfer). Obviously, any such matters would need to pass muster under local law.
C.
Partnership Elections 1. The importance of addressing issues up-front is particularly acute in the case of partnership elections. U.S. partners will want to retain control over all U.S. tax-related elections and should make sure that this issue is addressed in the partnerships organizational documents. Elections that could have a material impact on the U.S. partners include a 195 election to amortize start-up expenses, a 709 election to amortize organizational expenses, and a 754 election to adjust the basis of partnership property. Section 703(b) requires any election affecting the computation of taxable income derived from a partnership to be made by the partnership itself. A foreign partnership that does not have U.S. source gross income or U.S. effectively connected gross income is not required to file a U.S. federal income tax return. Nevertheless, a foreign partnership must file a return for the partnerships elections to be effective. Atlantic Veneer Corporation v. Commissioner, 812 F. 2d 158 (4th Cir. 1987). The regulations state that a return filed for the purposes of making elections must be signed either by each partner that is a partner at the time the election is made, or any partner who is authorized under local law or the partnerships organizational documents to make the election. Treas. Reg. 1.6031(a)-1(b)(5). It is important
2.
3.
for a number of reasons that the partnership agreement authorizes a partner to file a return for the purpose of making elections. Such an authorization avoids any issues with getting all partners to sign the U.S. partnership return. A return filed by a partner who is authorized to do so need not be a full-fledged return, but simply needs to state the name and address of the partnership and the election(s) being made. As further discussed below, a return filed by a partner who is authorized to do so is not treated as a return under 6031(a). Partners likely will not want to rely on local law to take care of such an important issue. 4. While a U.S. Federal return need not be filed for the partnership entity to make a check-the-box election, the check-the-box regulations have a similar requirement. These regulations state that the requisite form (Form 8832) must be signed either by each member of the electing entity who is an owner at the time the election is filed or any officer, manager or member of the electing entity who is authorized under local law or the entitys organizational documents to make the election. Treas. Reg. 301.7701-3(c)(1)(i). Thus, the partnership agreement also should authorize an appropriate person or persons to make check-the-box elections. This authorization also should apply to cases where the entity makes a check-the-box election on behalf of a subsidiary. A partnerships making of a 195 election to amortize start-up expenditures can be very important. (a) A taxpayer must capitalize start-up expenditures, unless the taxpayer makes an election under 195(b) to amortize such expenditures over 180 months beginning in the month in which an active trade or business begins. A 195(b) election cannot be made later than the time for filing the tax return for the year in which the trade or business begins. 195(d). Costs of expansion that would be deductible as an ordinary and necessary business expense under 162 if incurred by a partner, may a start-up expenditure if incurred by a newly formed partnership, thus necessitating a 195(b) election. Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521, (1979), aff'd, 633 F.2d 512 (7th Cir. 1980). "Start-up expenditures" are defined to mean any amounts paid or incurred in connection with:
5.
(b)
(c)
(i) (ii) (iii)
investigating the creation or acquisition of an active trade or business, creating an active trade or business, or any activity engaged in for profit and for the production of income, before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, and which if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the trade or business referred to above) would be allowable as a deduction for the taxable year in which paid or incurred. 195(c)(1).
(d)
"Start-up expenditures" do not include amounts deductible under 163(a) (interest), 164 (taxes), or 174 (research or experimental expenditures). Id. There is no clear standard for determining when an active trade or business begins, but the consensus of the authorities suggests that a trade or business begins when the business earns revenue. See Richmond Television Corp. v. United States, 345 F.2d 901 (4th Cir. 1965) (a taxpayer has not engaged in carrying on any trade or business within the intent of 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized); Kennedy v. Commissioner, 32 T.C.M. 52 (1973), (taxpayer held not to be "carrying on" a trade or business under 162(a) until the date he first opened the pharmacy doors to the public, notwithstanding the fact that he was legally capable of filling prescriptions at an earlier date); and LTR 9331001 (April 23, 1993) ( 195 applied to opening of first retail store by manufacturer/ wholesale distributor; and costs of opening subsequent retail stores were not subject to 195).
(e)
D.
Partnership Returns 1. A foreign partnership that does not have U.S. source gross income or U.S. effectively connected gross income is not required to file a U.S. return.
(a)
Section 6231(a)(1)(A) defines the term partnership to include any partnership that is required to file a U.S. Federal income tax return pursuant to 6031(a). Section 6031(e), which was enacted as part of the Taxpayer Relief Act of 1997, exempted foreign partnerships without U.S. source gross income or U.S. effectively connected income from being required to file a U.S. Federal income tax return under 6031(a).
(b)
2.
A foreign partnership that is not required to file, and does not file, a U.S. federal income tax return is exempted from the TEFRA audit rules and procedures, which generally consist of a separate audit of the partnership return in respect of partnership items and specific procedures related thereto. A U.S. partnership return filed by one partner with authority to do so solely for the purpose of making partnership-level elections does not cause a foreign partnership to be characterized as being required to file a U.S. income tax return under 6031(a). Therefore, a partnership that files such a return is not subject to the TEFRA rules. Treas. Reg. 1.6031(a)-1(b)(5). On the other hand, a foreign partnership with no U.S. source gross income or effectively connected income that files a return (even though it is not required to do so) would appear to be subject to the TEFRA rules. See 6233, and FSA 200149019 (Dec. 7, 2001). Thus, it appears that a foreign partnership that otherwise is not subject to the TEFRA rules may effectively elect into the TEFRA rules by filing a U.S. federal income tax return. It would seem unnecessary for a partnership to do so.
3.
4.
E.
Transfer of Assets to a Foreign Partnership 1. As a general matter no gain or loss is recognized on a transfer of property to a foreign partnership in exchange for a partnership interest. 721 Sections 721(c), (d) and 367(d)(3) authorize the Service to write regulations treating certain transfers of property to a partnership with foreign partners as taxable. (a) These rules potentially apply both to domestic and foreign partnerships. The salient factor is whether income or gain derived from property contributed by a U.S. partner could be allocated to a foreign partner. The purpose of these
2.
rules, which are linked to the 367(a) outbound transfer regime, is to impose an exit tax on appreciated tangible property and intangible property (whether appreciated or not) that leaves the U.S. taxing jurisdiction. (b) The Service has not written regulations under these provisions, and therefore they presently are not operative. Further, regulations seem largely unnecessary since 704(c), although not specifically written in the international context, largely takes care of these policy concerns. If the Service ever writes regulations, presumably they simply would serve as a backstop to 704(c). (See discussion of 704(c) in section III.E. below)
3.
The transfer of rights to intellectual property to a partnership raises issues in respect of whether the rights qualify as property, and thus is entitled to the protection of 721. Most of the authority in this area is in the context of transfers to corporations and 351. Although the statutory schemes of 351 and 721 are not entirely analogous, precedents under one section should be relevant to the other. See United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984). (a) The Service's published position with respect to transfers of know-how or patents is that a transfer will constitute a transfer of property within the meaning of 351 only if in a taxable transaction it would constitute a "sale or exchange" of property rather than a license for purposes of determining gain or loss. See Rev. Rul. 69-156, 1969-1 C.B. 101; Rev. Rul. 64-56, C.B. 1964-1 (Part I), 133. A "sale or exchange" requires a transfer of all substantial rights. The position of decided case law differs from that of the Service. In E.I. Du Pont de Nemours & Co. v. United States, 471 F.2d 1211 (Ct. Cl. 1973), the Court of Claims considered whether a non-exclusive patent license to a wholly-owned foreign subsidiary qualified under 351 of the Code. The taxpayer granted to its wholly-owned subsidiary a royalty-free, non-exclusive license to make, use and sell three of its herbicides under French patents for the remaining life of the French patents in exchange for stock valued at approximately $400,000. The court held that the transfer of the nonexclusive license qualified under
(b)
351 even though the transaction would not be a sale or exchange under 1221 or 1231. The court noted that 351 was premised on the fact that the taxpayer continues the business merely in a different form, whereas the capital gains provision determines whether there has been a full and complete divestiture of the taxpayer's interest in the property. Thus, it would be anomalous to require more complete divestiture under 351 to obtain non-recognition when the purpose for non-recognition is retention of control of the assets transferred in corporate form. Consequently, the court held that the transfer qualified under 351. After dismissing the government's application of capital gains concepts in the context of 351, the court went on to determine that the nonexclusive license constituted "property" and that the grant of the license in return for stock constituted a transfer in exchange for stock for purposes of 351. See also H. B. Zachry Co. v. Commissioner, 49 T.C. 73 (1967) (cited in Du Pont), where the Tax Court determined that the transfer of a carved out oil payment was a transfer of property for 351. The Tax Court also rejected the Service's argument that the transaction had to qualify as a sale or exchange for capital gains purposes to qualify under 351. (c) Subsequent to Du Pont, the Service issued three GCMs in which it acknowledged that the court in Du Pont reached the right result. Consequently, the GCMs state that the Service's position is no longer that all substantial rights to know-how or patents have to be transferred in order to qualify under 351. The GCMs recommended that the Service publish rulings indicating that the Service would follow Du Pont. See GCM 36922 (November 16, 1976); GCM 37178 (June 24, 1977); GCM 38114 (September 27, 1979). The Service, however, has not issued a revenue ruling stating that it will follow Du Pont. With respect to know-how, Rev. Rul. 64-56, 1964-1 (Part I) C.B. 133, states that the Service will recognize know-how and trade secrets as property for purposes of 351. This category of property includes: (i) anything qualifying as a secret process or formula within the meaning of 861(a) (4) and 862(a)(4); and
(d)
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(ii)
any other 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. Any other information which is secret will be given consideration as "property" on a case-by-case basis. Rev. Rul. 64-56 notes that when know-how has been developed specially for the transferee, the stock received in a 351 exchange may be treated as payment for services rather than as an exchange of property for stock. See also Rev. Proc. 69-19, 1969-2 C.B. 301 which provides guidelines for when know-how will be treated as property for purposes of advance rulings under old 367 and 351. Rev. Proc. 69-19 requires representations that the "information" is "original, unique, and novel," is not disclosed by the product on which it is used or to which it is related, and 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 and adequate safeguards have been taken to guard the secret against unauthorized disclosure."
(iii)
(e)
Transfers of rights other than rights in technology. (i) In Ungar v. Commissioner, 22 T.C.M. 766 (1963), the court held that the transfer of a contract for the purchase of real property negotiated by the transferor constituted property for purposes of 351. In Stafford, supra, the court held that a contribution by a partner to a partnership of a letter of intent for financing from a life insurance company was a contribution of property under 721, even though the letter of intent was not enforceable. See also Mark IV Pictures, Inc. v. Commissioner, 60 T.C.M 1171, aff'd, 969 F.2d 669 (8th Cir. 1992) (the fact that partners can demonstrate that they were separately and adequately paid for their services, tends to show that they received their partnership interest in exchange for the contribution of
(ii)
property; in this case the taxpayer failed to show adequate compensation). (iii) In Hospital Corporation of America v. Commissioner, 81 T.C. 520 (1983), the Tax Court held that the diversion of a corporate opportunity to negotiate and perform a contract was not a transfer of property under 351.
(f)
The tax treatment of the transfers of intangible property to a partnership can be different if the U.S. transferor receives only a profits interest in the Joint Venture and no capital account credit, in exchange for the transfer of intangible property. In this case, even if the transaction does not qualify under 721(a), arguably the U.S. transferor would be taxed only when Joint Venture profits were subsequently allocated to it.
4.
The reporting requirements of 6038B apply to contributions to foreign partnerships by a U.S. person who, immediately after the contribution, holds a 10% interest in the partnership, or who transfers more than $100,000 in value during a 12 month period. Treas. Reg. 1.6038B-2. Reporting is done on Form 8865.
F.
Section 704(c) Issues 1. Generally 704(c) and Treas. Reg. 1.704-3 and 4, require any built-in gain or loss in contributed property (i.e., the difference between the propertys 704(b) book basis and its adjusted tax basis) to be allocated to the contributing partner upon a subsequent sale or distribution (within 7 years) of the contributed property. Section 737 acts as a backstop to 704(c) when a partnership distributes other property to the contributing partner within 7 years. The purpose of 704(c) is to prevent the shifting of tax consequences among partners with respect to property contributed to a partnership with built-in gain or loss at the time of contribution. The regulations under 704(c) prescribe three methods to achieve this objective. Two such methods (the traditional method with curative allocations and the remedial method) permit a partnership to specially allocate items of income or loss that are not generated by the 704(c) property at issue. For example, if in a two-partner partnership, the U.S. partner (USP) contributes property with an adjusted tax basis of $0 and a 704(b) book value of $100, these
2.
two methods would permit deductions generated by the partnership from other activities or notional deductions to be specially allocated to the foreign (FP), and income generated by the partnership from other activities or notional income to be specially allocated to USP as the propertys 704(b) book value depreciates. The third method (the traditional method) does not permit special allocations of income or loss not generated by the property at issue, and thus book-tax differences would only be remedied on a later disposition (if any book-tax difference exists at that time). 3. The 704(c) regulations contain an anti-abuse rule that can apply if a 704(c) method is selected with a view towards shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners aggregate tax liability. Treas. Reg. 1.704-3(a)(10). The antiabuse rule merits special attention where there are foreign partners to whom income could be shifted with no U.S. tax consequence to them. Therefore, U.S. partners need to carefully think through the selection of 704(c) methods if items of property with book-tax differences will be contributed to the partnership. These matters should be covered in the partnership agreement itself to prevent any later confusion amongst the partners and to reduce the possibility of challenge by the Service. An important issue is whether use of the traditional method would pass muster when a U.S. partner contributes built-in gain property that is subject to the ceiling rule. This could occur, for example, if the U.S. partner contributes zero basis property, such as IP, to the partnership. (a) Treas. Reg. 1.704-3(b)(2), Example 2 provides an example of an unreasonable use of the traditional method in respect of property subject to the ceiling rule. (The ceiling rule provides that the total income, gain, loss, or deduction allocated to the partners for a taxable year with respect to a property cannot exceed the total partnership income, gain, loss, or deduction with respect to that property for the taxable year. Treas. Reg. 1.704-3(b)(1).) In this example, partners C and D form a partnership in which they agree to allocate tax items 50-50. The example states that D has substantial NOL carryovers, but D also could be a foreign partner who is not subject to U.S. tax. C contributes property with an adjusted tax basis of $1,000 and a 704(b) book value of $10,000. The property has
4.
(b)
only one year of tax depreciation remaining at the time of contribution. Thus, after one year, both the propertys adjusted tax basis and its 704(b) book value are $0, and accordingly, no further 704(c) allocation is required in respect of this property. In the next year the property is sold, and the partnerships gain is allocated 50-50 amongst C and D (i.e., there is no 704(c) special allocation of income to C). (c) The example states that the use of the traditional method is unreasonable. It states that the interaction of the partnerships one-year write-off of the entire book value of the property and the use of the traditional method results in a shift of $4,000 of the precontribution gain to D (who has substantial NOL carryovers). It further states that the traditional method was used with a view to shifting a significant amount of taxable income to a partner with a low marginal tax rate (D) and away from a partner with a high marginal tax rate (C). The example provides for a safe harbor against application of the anti-abuse rule, stating that the partnerships use of the traditional method would not be unreasonable if the partnership agreement in effect for the year of contribution had provided that tax gain from the sale of the property (if any) would always be allocated to C to offset the effect of the ceiling rule limitation. The example cites Treas. Reg. 1.704-3(c)(3), which states that a partnership may make curative allocations in a taxable year to offset the effect of the ceiling rule for a prior taxable year if these allocations are made over a reasonable period of time, such as the propertys economic life, and are provided for in the partnership agreement in effect for the year of contribution. The safe harbor deviates from a strict application of an overriding principle of the regulations. The regulations state that built-in gain (or loss) is reduced by decreases in the difference between propertys book value and adjusted tax basis. The safe harbor, by contrast, freezes the amount of built-in gain (or loss) that is subject to the ceiling rule, and this frozen amount is given tax effect at a later date, even though the amount of the propertys book-tax difference that is subject to the ceiling rule might have decreased or disappeared by then.
(d)
(e)
(f)
The regulations provide no other safe harbor in respect of the traditional method other than this rather awkward application of 704(c). Does this suggest that a partnership with U.S. and foreign partners should only use the safe harbor, or abandon the traditional method altogether, when a U.S. partner contributes property that is subject to the ceiling rule? Certainly the partnership needs to be careful in its use of the traditional method, but there should be other ways of avoiding charges of abuse. If not, then a strict application of the traditional method never would be permitted under the facts of the example or similar facts. The regulations do not state that this is the case. Another approach not discussed in the example also would appear to be reasonable. If the contributed property in the example had a $0 adjusted tax basis (as is typically the case with the transfer of IP, for example), then the partnership could have chosen any reasonable depreciation convention for 704(b) book purposes. Treas. Reg. 1.7041(b)(2)(iv)(g)(3) Thus, suppose that the contributed property had a $0 adjusted tax basis, and the partnership, rather than depreciating 100% of the propertys 704(b) book value in year 1, had chosen a depreciation convention that accurately reflected the propertys remaining economic life. Accordingly, when the property was sold in year 2, C would have been specially allocated a certain amount of gain under 704(c). This amount would have been less than $4,000 (the amount initially subject to the ceiling rule), but if the 704(b) book depreciation convention reasonably reflected the propertys remaining useful life, it could be strongly argued that the property was not contributed to the partnership with a view to shifting taxable income. Of course, the partnership would have the burden of proving that the 704(b) depreciation convention it selected was reasonable. If this approach were not treated as reasonable, then the traditional method, absent application of the safe harbor, would be de facto unreasonable under the facts of Example 2 or similar facts. As stated, the regulations do not state that this is the case.
(g)
5.
A mirror issue applies if a foreign partner contributes property subject to the ceiling rule and the partnership chooses the traditional method with curative allocations or the remedial method. The facts of Treas. Reg. 1.704-3(c)(4), Example 3
mirror the facts of Treas. Reg. 1.704-3(b)(2), Example 2 except that the partner with NOL carryovers (or for purposes of this discussion, the foreign partner) contributes the 704(c) property subject to the ceiling rule; also, the property is not sold. The example states that a curative allocation that eliminates the entire book-tax difference in the first year is not reasonable since the propertys useful life is longer than one year. The example states that curative allocations would be reasonable if they are made over a reasonable period of time, such as over the propertys economic life, rather than over its remaining cost recovery period. 6. Thus, both a partnerships use of the traditional method when a U.S. partner contributes property subject to the ceiling rule and a partnerships use of the traditional method with curative allocations or the remedial method when a foreign partner contributes property subject to the ceiling seem to be reasonable as long as the amount subject to the ceiling rule is not eliminated through 704(b) book depreciation that outstrips the propertys reasonably expected economic life. Finally, note that 704(c) and the regulations thereunder apply on a property-by-property basis. Treas. Reg. 1.704-3(a)(2). Accordingly, different methods can be applied to different items of contributed property. However, the regulations state that the method or methods selected must be reasonable in light of the facts and circumstances and consistent with the purpose of 704(c). Thus, if both U.S. and foreign partners contribute property that is subject to the ceiling rule, then the partnership needs to be careful how it picks and chooses its methods.
7.
G.
Dual Consolidated Loss Issues ( 1503(d)) 1. Overview (a) New DCL regulations were issued in March 2007. Unlike the old DCL regulations, which were reserved on partnership interests, the new regulations provide a number of specific rules The baseline rule is that a U.S. taxpayer cannot use a DCL to offset its income. The regulations define DCL broadly, as essentially any NOL of the dual resident corporation or a pass-through entity. Treas. Reg. 1.1503(d)-1(b)(5).
(b)
(c)
A U.S. taxpayer can use a DCL, however, to offset its income, if it makes a domestic use election. Treas. Reg. 1.1503(d)-6(d). The crux of this election is that the taxpayer must certify that no portion of the losses, expenses, or deductions taken into account in determining the DCL has been, or will be, used to offset the income of any other person under the income tax laws of a foreign country (foreign use). This is an all or nothing rule, so that if one dollar of the certified DCLs is used to offset the income of another person under foreign law, all the DCLs will be disallowed as a deduction.
2.
DCLs and Partnership Interests (a) General rule. A foreign use is not considered to occur if the foreign use is solely the result of another persons ownership of an interest in a partnership and the allocation or carry forward of an item of deduction or loss composing such DCL as a result of such ownership. Treas. Reg. 1.1503(d)-3(c)(4)(i). See Treas. Reg. 1.1503(d)-7(c) Example 13. Combined Separate Unit. This rule applies to a DCL attributable to a combined separate unit (see Treas. Reg. 1.1503(d)-1(b)(4)) that includes an individual separate unit to which the general rule described in the above paragraph would apply, but for the application of the separate unit combination rule. In such a case, the general rule applies to the portion of the DCL of such combined separate unit that is attributable, as provided under Treas. Reg. 1.1503(d)-5(c) through (e), to the individual separate unit that is a component of the combined separate unit. Treas. Reg. 1.1503(d)-3(c)(4)(ii). See Treas. Reg. 1.1503(d)-7(c) Example 14. Reduction in Interest. The general rule described in (a) above does not apply if, at any time following the year in which the DCL is incurred, there is more than a de minimis reduction in the domestic owner's percentage interest in the partnership. In such a case, a foreign use is deemed to occur at the time the reduction in interest exceeds the de minimis amount. Treas. Reg. 1.1503(d)-3(c)(4)(iii). See Treas. Reg. 1.1503(d)-7(c), Example 13.
(b)
(c)
A reduction in interest is not treated as de minimis, and therefore a foreign use is deemed to occur if (A) During any 12-month period the domestic owner's percentage interest in the separate unit is reduced by 10 percent or more, as determined by reference to the domestic owner's interest at the beginning of the 12-month period; or (B) at any time the domestic owner's percentage interest in the separate unit is reduced by 30 percent or more, as determined by reference to the domestic owner's interest at the end of the taxable year in which the DCL was incurred. Treas. Reg. 1.1503(d)-3(c)(5)(ii). A reduction of a domestic owner's interest in a separate unit includes a reduction resulting from another person acquiring through sale, exchange, contribution, or other means, an interest in the foreign branch or hybrid entity, as applicable. A reduction may occur either directly or indirectly, including through an interest in a partnership, a disregarded entity, or a grantor trust through which a separate unit is carried on or owned. In the case of an interest in a hybrid entity partnership or a separate unit all or a portion of which is carried on or owned through a partnership, an interest in such separate unit (or portion of such separate unit) is determined by reference to the owner's interest in the profits or the capital in the separate unit. In the case of an interest in a hybrid entity grantor trust or a separate unit all or a portion of which is carried on or owned through a grantor trust, an interest in such separate unit (or portion of such separate unit) is determined by reference to the domestic owner's share of the assets and liabilities of the separate unit. Treas. Reg. 1.1503(d)-3(c)(5)(iii). Note that this rule could serioucly reduce flexibility in the conduct of international joint ventures. Any dilution in a domestic owners interest (beyond the de minimis amount) would cause a recapture of DCLs. For example, the unilateral contribution of capital by a new or existing foreign partner could give rise to a triggering event. Is this what Congress intended when it enacted 721 (no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership)?
(d)
Hybrid entity that is a partnership and partnership through which a domestic owner indirectly owns a separate unit. The adjusted basis of such an interest is adjusted in accordance with 705 and as follows. The adjusted basis is decreased for any amount of a DCL that is attributable to the partnership interest, or separate unit owned indirectly through the partnership interest, as applicable, that is not absorbed as a result of the application of Treas. Reg. 1.1503(d)-4(b) and (c). The adjusted basis, however, is decreased for the amount of such DCL that is absorbed in a carryover or carryback taxable year. The adjusted basis is increased for any amount included in income pursuant to Treas. Reg. 1.1503(d)-6(h) as a result of the recapture of a DCL that was attributable to the interest in the hybrid partnership, or separate unit owned indirectly through the partnership interest, as applicable. Treas. Reg. 1.1503(d)5(g)(2). Special Rules apply to a Transparent Entity, which is defined in Treas. Reg. 1.1503(d)-1(b)(16) as an entity that: (i) (ii) Is not taxable as an association for Federal tax purposes; Is not subject to income tax in a foreign country as a corporation (or otherwise at the entity level) either on its worldwide income or on a residence basis; and Is not a pass-through entity under the laws of the applicable foreign country. For purposes of applying the preceding sentence, the applicable foreign country is the foreign country in which the relevant foreign branch separate unit is located, or the foreign country that subjects the relevant hybrid entity (an interest in which is a separate unit) or DRC to an income tax either on its worldwide income or on a residence basis. Example. A U.S. limited liability company (LLC) does not elect to be taxed as an association for Federal tax purposes and is not subject to income tax in a foreign country as a corporation (or otherwise at the entity level) either on its worldwide
(e)
(iii)
income or on a residence basis. The LLC is owned by a hybrid entity (an interest in which is a separate unit) that is the relevant hybrid entity. Provided the LLC is not treated as a pass-through entity by the applicable foreign country that subjects the relevant hybrid entity to an income tax either on its worldwide income or on a residence basis, the LLC would qualify as a transparent entity. See also Treas. Reg. 1.1503(d)-7(c) Example 26. (f) See Treas. Reg. 1.1503(d)-5(c) for rules on attributing items of income, gain, deduction, and loss to interests in transparent entities. The rules applicable for attributing items to these interests are consistent with the rules for attributing items to hybrid entity separate units. Any items of income, gain, deduction, and loss that are attributable to a separate unit or an interest in a transparent entity of the DRC are not taken into account in determining the DCL of the DRC. Treas. Reg. 1.1503(d)-5(b)(2). The Preamble to the old DCL regulations states that the Service is concerned with abusive double dipping in respect of special allocations of partnership loss where a single item of economic loss is used to offset one stream of income for U.S. tax purposes and a separate stream of income for foreign tax purposes. The Preamble states that the Service is considering including within the definition of DCL a special allocation of a single item of loss to a domestic partner for U.S. tax purposes and to a foreign partner for foreign tax purposes. T.D. 8434, 1992-2 C.B. 240, 243. See also FSA 1999-900, 1999 TNT 40-55; and FSA 200221018 (a DCL can be used by another person if partnership losses are shared through the making of allocations of income and expenses that differ between U.S. tax law and foreign tax law). While this statement is not echoed in the Preamble to the new DLC regulations, special allocations could be subject to scrutiny. AM 2009-011. In Generic Legal Advice Memo, AM 2009011 (Oct. 2, 2009), the National Office opined on certain issues related to foreign use of dual consolidated losses. Scenarios 2 and 3 involve partnerships.
(g)
(h)
(i)
Assumed Facts (i) (ii) USP is a domestic corporation that files a U.S. income tax return on a calendar year basis. FEX is an entity organized under the laws of Country X that is subject to Country X income tax on its worldwide income. FEX files its Country X income tax return on a calendar year basis. Under Country X laws, items of deduction or loss incurred by FEX in a taxable year are available to offset or reduce any item of income or gain incurred by FEX during such taxable year. Country X laws do not permit FEX to carry back losses to taxable years prior to the taxable year in which the losses were incurred. One or more of the deductions or losses taken into account in computing all DCLs are recognized as deductions or losses under the laws of Country X. FEX carries on a business operation in Country X that, if carried on by a U.S. person, would constitute a foreign branch within the meaning of Treas. Reg. 1.367(a)-6T(g)(1). For periods in which FEX is classified as a partnership or a disregarded entity for federal tax purposes, USP's interest in FEX constitutes a hybrid entity separate unit within the meaning of Treas. Reg. 1.1503(d)-1(b)(4)(i)(B), and USP's indirect interest in its share of the business operations conducted by FEX constitutes a foreign branch separate unit within the meaning of Treas. Reg. 1.1503(d)-1(b)(4)(i)(A). These two individual separate units are combined and treated as one separate unit (FEX Separate Unit).
(iii)
(iv)
(v)
(vi)
Scenario 2 Facts USP has owned 100 percent of the stock of FEX since its formation on January 1, year 1. Effective as of the date of
its formation, FEX elected to be treated as a disregarded entity for U.S. tax purposes A DCL is attributable to the FEX Separate Unit in year 1 (Year 1 DCL). USP timely filed a domestic use election with respect to the Year 1 DCL and such loss therefore was included in the computation of USP's taxable income for year 1. On January 1, year 3, USP sold for cash two percent of its interest in FEX to FC, an unrelated foreign corporation. Although this sale resulted in a foreign use of the Year 1 DCL as described in Treas. Reg. 1.1503(d)-3(a)(1), it did not constitute a foreign use because it qualified for the de minimis exception provided under Treas. Reg. 1.1503(d)3(c)(5). On June 30, year 3, FC transferred its two percent interest in FEX to FS, a foreign corporation wholly owned by FC. This transfer also resulted in a foreign use of the Year 1 DCL as described in Treas. Reg. 1.1503(d)-3(a)(1). The issue is whether the de minimis exception applies to the June 30, year 3, transfer of the FEX interest from FC to FS such that no foreign use of the Year 1 DCL is considered to occur. Analysis The de minimis exception states that no foreign use of a DCL will be considered to occur as a result of an item of deduction or loss composing such DCL being made available "solely" as a result of a de minimis reduction of the domestic owner's interest in the separate unit. USP's sale of the two percent interest in FEX to FC is a de minimis reduction of USP's interest in the FEX Separate Unit, and the resulting foreign use of the Year 1 DCL is solely the result of that reduction. Consequently, the de minimis exception applies and no foreign use is considered to occur. FC's subsequent transfer of the two percent interest in FEX to FS does not change this result. Although the transfer also results in a foreign use of the Year 1 DCL as described in Treas. Reg. 1.1503(d)-3(a), this use occurred with respect
to the same interest in the FEX Separate Unit the sale of which qualified for the de minimis exception (that is, the two percent interest sold by USP on January 1, year 3). As a result, this foreign use is also considered to arise solely as a result of the reduction in USP's interest in the FEX Separate Unit. Therefore, the de minimis exception applies and FC's transfer of the FEX interest to FS does not result in a foreign use of the Year 1 DCL. Scenario 3: Facts USP and USD, an unrelated domestic corporation, formed FEX on January 1, year 3. USP and USD each owned 50 percent of the interests in FEX. Effective as of the date of its formation, FEX elected to be classified as a partnership for federal tax purposes under Treas. Reg. 301.7701-3(a). A DCL is attributable to the FEX Separate Unit in year 3 (Year 3 DCL). USP timely filed a domestic use election with respect to the Year 3 DCL and such loss therefore was included in the computation of USP's taxable income for year 3. On January 1, Year 5, USP sold for cash 20 percent of its interest in FEX (a non-de minimis amount per Treas. Reg. 1.1503(d)-3(c)(4)(iii) discussed below) to USD. The issue is whether the January 1, year 5, sale of the FEX interest results in a foreign use of the Year 3 DCL pursuant to the last sentence of Treas. Reg. 1.1503(d)-3(c)(4)(iii). Analysis Treas. Reg. 1.1503(d)-3(c)(4) provides an exception to foreign use for certain interests in partnerships or grantor trusts ("(c)(4) exception"). The (c)(4) exception applies to a DCL attributable to an interest in a hybrid entity partnership or a hybrid entity grantor trust, or to a separate unit owned indirectly through a partnership or grantor trust. Under this exception, a foreign use will not be considered to occur if the foreign use is solely the result of another person's ownership of an interest in the partnership or
grantor trust, as applicable, and the allocation or carry forward of an item of deduction or loss composing the DCL as a result of such ownership. The exception is limited by Treas. Reg. 1.1503(d)-3(c)(4)(iii) ("(c)(4) limitation"), which provides in general that the exception will not apply if , at any time following the year in which the dual consolidated loss is incurred, there is more than a de minimis reduction in the domestic owner's percentage interest in the partnership or grantor trust. The GLAM states that the (c)(4) limitation can only prevent the application of the (c)(4) exception to what would otherwise be a foreign use. Neither the (c)(4) limitation nor the (c)(4) exception can cause a foreign use that does not otherwise occur. This is evident from the general structure of Treas. Reg. 1.1503(d)-3(a), which indicates that one should first apply the general definition of foreign use, and then determine whether any of the exceptions apply. The general definition of foreign use is preceded by the clause "Except as provided in paragraph (c) of this section," which references exceptions to the general definition of foreign use, including the (c)(4) exception. The first sentence of the related provision of Treas. Reg. 1.1503(d)-3(c)(1) reinforces this principle by indicating that the (c)(4) exception constitutes an exception to the general definition of foreign use that only applies if there has otherwise been a foreign use. Thus, according to the Service, prior to analyzing the application of the (c)(4) exception and the (c)(4) limitation it must be determined whether there would otherwise be a foreign use. In years 3 and 4 there is no foreign use of the DCL within the meaning of Treas. Reg. 1.1503(d)-3(a). This is the case without regard to the application of the (c)(4) exception. The (c)(4) exception generally applies where a foreign use would otherwise occur solely as a result of another person's ownership of an interest in the partnership and the allocation or carry forward of an item of deduction or loss composing the DCL as a result of such ownership. Because USD is a domestic corporation, however, the allocation or carry forward of an item of deduction or loss composing the DCL does not result in a foreign use because the second condition of foreign use, described above, is not satisfied. That is, the item of income or gain that is referenced in the first condition of
foreign use is not considered under U.S. tax principles to be an item of a foreign corporation, or an item of a direct or indirect owner of an interest in a hybrid entity that is not a separate unit; instead, such item is an item of a domestic corporation that is the direct owner of an interest in a hybrid entity that is a separate unit. For the same reason, the January 1, year 5, sale by USP of the interest in FEX to USD, a domestic corporation, does not result in a foreign use of the year 3 DCL within the meaning of Treas. Reg. 1.1503(d)-3(a). Because there is no foreign use of the year 1 DCL within the meaning of Treas. Reg. 1.1503(d)-3(a), USP's sale of the FEX interest does not implicate the (c)(4) exception or the (c)(4) limitation. This is the case even though the amount of the separate unit that is sold is in excess of the de minimis amount of the separate unit permitted to be reduced in a given year under the (c)(4) limitation. Therefore, the last sentence of Treas. Reg. 1.1503(d)3(c)(4)(iii) does not cause the January 1, year 5, sale of the FEX interest to result in a foreign use. H. Section 987 Currency Rules 1. Section 987 provides rules for determining exchange gain or loss of a taxpayer which has a qualified business unit (QBU), which includes a partnership interest, with a functional currency different from the taxpayers. A principal component of these rules is 987(3) which calls for the Service to write regulations making proper adjustments whenever property is transferred between QBUs with different functional currencies. Proposed regulations issued in 1991 (1991 Proposed Regulations) were the Services first attempt at formulating a set of rules to implement the statute. The 1991 Proposed Regulations were replaced with new proposed regulations issued in 2006 (2006 Proposed Regulations) Summary of 1991 Proposed Regulations (a) 1991 Prop. Treas. Reg. 1.987-2 required taxpayers to maintain two pools in respect of certain foreign QBUsthe equity pool, which is kept in the QBUs functional currency, and the basis pool, which is kept in the home
2.
3.
offices functional currency and calculate currency gain or loss by reference to these pools. (b) The basis pool is roughly described as all of the QBUs accretions to wealth translated into the home offices functional currency at a running average exchange rate. When a QBU makes a remittance to the home office, the amount of the remittance is translated into the home offices functional currency at the spot rate on the day the remittance is made. Essentially, the value of the remittance at the spot rate is compared with the value of the remittance at the running average exchange rate to determine whether the taxpayer recognizes 987 gain or loss. Specifically, the 987 gain or loss under the 1991 Proposed Regulations was the difference between: (i) the amount of a remittance from a branch translated into the taxpayers functional currency at the spot rate on the date the remittance is made, and (ii) the portion of the basis pool attributable to the remittance. The formula for determining the portion of the basis pool attributable to a remittance is as follows:
Amount of remittance (in the branchs Basis pool reduced by functional currency) X prior remittances Equity pool balance reduced by prior remittances
(c)
If the QBUs currency on the date of the remittance is stronger than the running average, the home office recognizes currency gain, and if the QBUs currency on the date of the remittance is weaker than the running average, the home office recognizes currency loss. Accordingly, under the proposed regulations every remittance from a branch to the home office potentially, and likely, results in the recognition of exchange gain or loss. (d) 4. The 1991 Proposed Regulations reserved on how to coordinate the 987 rules and the partnership rules.
In Notice 2000-20, 2000-14 I.R.B. 851, the Service stated that it was planning to review and possibly replace the 1991 Proposed Regulations. The Service stated that it and Treasury were concerned that the 1991 Proposed Regulations may not have fully achieved their original goal of providing rules that are
administrable and result in the recognition of foreign currency gains and losses under the appropriate circumstances. 5. 6. The 2006 Proposed Regulations introduce a regime that differs in many fundamental respects from the 1991 Proposed Regulations. The 2006 Proposed Regulations depart from the profit and loss method of accounting for a QBUs income, gain, deduction, and loss. The profit and loss method was adopted by the 1991 Proposed Regulations and is consistent with the statute and legislative history. Under the 2006 Proposed Regulations an owner must determine its taxable income attributable to a QBUs activities under a DASDM-like approach, by translating, often at different exchange rates, each item of the QBUs income, gain, deduction, and loss. The value of certain items (e.g., inventory) is determined by reference to the exchange rate in effect when the QBU acquired them. As a result, an owner can effectively recognize currency gain or loss in respect of these items when it annually reports its taxable income or loss attributable to the QBUs activities. The amount of an owners gain or loss on remittances is determined by reference neither to the QBUs earnings or capital, methods which Treasury and the Service had previously considered. Rather, gain or loss on remittances is determined by reference to the QBUs items denominated in (or determined by reference to) the QBUs functional currency that would be 988 transactions in the hands of the owner. The owner must track the amount by which these items fluctuate in value due to exchange rate movements between the owners and the QBUs functional currencies (net unrealized 987 gain or loss). Partnerships are generally treated as aggregates under the 2006 Proposed Regulations, and thus the principles of subchapter K are secondary to 987 in many respects. An individual or a corporation that is a partner in a partnership is treated as an owner of an eligible QBU of the partnership to the extent that it is allocated under Prop. Treas. Reg. 1.987-7 of all or a portion of the assets and liabilities of the eligible QBU of the partnership. (a) The 2006 Proposed Regulations state that a partners share of the QBUs assets and liabilities is determined in a manner that is consistent with the manner win which the
7.
8.
9.
partners have agreed to share the economic benefits and burdens (if any) corresponding to the assets and liabilities, taking into account the principles of subchapter K and the regulations thereunder. (b) This guidance is sketchy. The sharing of the economic benefits and burdens of assets and liabilities is not always (or even usually) made explicit in the partnership agreement. For example, suppose two partners agree to share all partnership items 50-50, except that one partner receives an annual allocation of gross income before the remaining items are split evenly. Or suppose that two partners agree to split all partnership items 50-50, except that one partner contributes all of the initial capital. It is not clear how partners who enter into these types of arrangements (which are not uncommon) would determine their respective shares of the economic benefits and burdens of partnership assets and liabilities. Would the partners be treated under the proposed regulations as sharing assets and liabilities 50-50, or must the gross income allocation or initial capital contribution be taken into account, and if so, how?
10.
There is a fundamental conflict between how the 2006 Proposed Regulations seek to apply 987 to remittances from partnerships and the principles of Subchapter K. The 2006 Proposed Regulations turn every remittance from a 987 partnership to its partners into a potential, and likely, recognition event. (While the 1991 Proposed Regulations reserved on partnerships, their rules on branch remittances, if applied to partnerships, would have had the a similar result.) Subchapter K, however, calls for the recognition of gain or loss on partnership distributions only in limited circumstances, principally when the amount of cash or cash equivalents distributed to a partner exceeds the partners adjusted basis in its partnership interest. 731(a)(1). For a number of reasons, the coordination of 987 and Subchapter K should defer to Subchapter K. (a) First, there would be serious issues of practicality and administerability if 987 operated independently of Subchapter K. Every distribution from a partnership would be a potential, and likely, recognition event for the U.S. partners. The prospect of tax on every distribution has its own issues in the context of a wholly owned branch, but these issues are multiplied in the case of a partnership with
foreign partners who are unaffected by 987. For example, imagine how foreign partners would react to a demand by U.S. partners that the amount of every cash distribution be adjusted to take into account 987 gain or loss. On too many occasions, this simply would not be workable, and it would run counter to the Services statement in Notice 2000-20 that it desires rules that are administrable. (b) Second, there is an important legal issue. It is by no means clear that the Service has the legal authority effectively to override Subchapter K by treating every partnership distribution as a potential, and likely, recognition event. Section 731(a) is explicit that a partner is taxed on a distribution from a partnership only in certain narrow circumstanceswhen the distribution of money (or money equivalents) exceeds the partners adjusted basis in its partnership interest, or in the case of a loss, only on a distribution in liquidation of the partners interest in the partnership. Legislative history confirms that Congress intended to tax distributions from partnerships only rarely.
These new distribution rules limit quite narrowly the area in which gain or loss is recognized upon a distribution. . . . These rules, combined with the nonrecognition of gain or loss upon contribution of property to a partnership, will remove deterrents to property being moved in and out of partnerships as business reasons dictate. Internal Revenue Code of 1954 Senate Committee Report, p. 4729.
Unlike the partnership rules, which are clear in their language and intent, 987 is anything but clear. Section 987(3) does not mention partnerships, much less sanction an override of subchapter K. While the definition of QBU covers partnerships, the legislative history underlying 987 is silent as to partnership distributions and the interrelationship between 987 and Subchapter K. Indeed, the relevant legislative history does not even use the term partnership. In this regard, the legislative history underlying the 987 remittance rules is under the heading Foreign branches. Thus, it is far from clear whether Congress seriously thought about the effect of the 987 remittance rules on Subchapter K, or much less intended that 987 effect a radical overhaul of Subchapter K. See also J.N. Ledbetter v. U.S., 792 F. 2d 1015 (11th Cir. 1986)
(regulation under old 1348 held invalid because it conflicted with 707(c)); and Zahler v. Commissioner, 684 F. 2d 356 (6th Cir. 1982), revg. and remg. T.C.M. 1981112 (same result); cf. Kampel v. Commissioner, 634 F. 2d 708 (2d Cir. 1980), affg. 72 T.C. 827 (1979) (same regulation held to be valid, but without any analysis or discussion regarding any conflict between the statute and the regulation) (c) Third, there is an inherent double taxation issue when 987 operates independently of Subchapter K. The 2006 Proposed Regulations create a legal fiction to resolve this double taxation issue. The Proposed Regulations state that for purposes of determining a partners basis in its partnership interest under 705, any 987 gain or loss recognized by the partner in respect of a 987 QBU held by a partnership is the partnerships gain or loss. The need to create such a fiction is perhaps another indication that it would be more appropriate to fit the operation of 987 within the rubric of subchapter K rather than superimpose 987 on top of subchapter K. Given these issues, it would seem to be more sensible to fit the principles of 987 within the existing framework of Subchapter K rather than to superimpose the principles 987 onto Subchapter K. This could be accomplished rather simply. A U.S. partner in a partnership which has a functional currency other than the dollar could be required to keep its basis in its partnership interest in dollars under the principles of 705 with issues of currency translation governed by 987. In accordance with the legislative history and the proposed regulations underlying 987, every distribution of cash or property from a partnership could be translated from the partnerships functional currency into dollars at the spot rate on the date of the remittance. The partnership rules of 731-733 would govern whether and the extent to which gain or loss is recognized as a result of the distribution. (i) For example, suppose that USP contributed $100 to a partnership with the Euro as its functional currency at a time when the Euro to dollar exchange rate is 1:$1. Thus, USPs basis in the partnership would be $100. Suppose that the Euro appreciates in value to 3:1, and the partnership distributes 50.
(d)
The partnership would not recognize currency gain since its functional currency is the Euro. Pursuant to 987, USP would translate the distribution into dollars at the spot rate on the date of the distribution. Thus, USP would be treated as receiving $150. USP would recognize $50 of gain pursuant to 731(a)(1), and USPs basis in its partnership interest would be reduced to zero under 733. The gain should be capital gain. Future cash remittances would result in USP recognizing gain if its basis in its partnership interest is not increased in the interim. (ii) Suppose that if instead of receiving 50 worth of cash, USP received 50 worth of property. Pursuant to 987, USP would translate the distribution into dollars at the spot rate on the date of the distribution, and thus be treated as receiving $150 worth of property. Pursuant to 731, USP would not recognize gain on the distribution. USP would take a $100 basis in the property under 732, and its basis in its partnership interest would be reduced to zero under 733. As another example, suppose that FP distributes 50 in cash, but the value of the Euro declines to 1:$3. In this case under the principles of 987 USP would be treated as receiving $17 from FP. USP would not recognize gain or loss under 731, and USPs basis in FP would decrease from $100 to $83. USP also would not recognize currency loss. Similar rules could apply in the context of a partnership termination, again with the rules of 731 applying, as adjusted to reflect currency gain or loss. This method would be simple, practical, administrable, transparent to foreign partners, and would fit comfortably within the statutory frameworks and intent of both 987 and Subchapter K.
(iii)
(iv)
(v)
11.
The 2006 Proposed Regulations also can produce overrides of 721. Somewhat counterintuitively, contributions to a partnership
could give rise to gain or loss under 987(3). An asset or liability is treated as transferred from a 987 QBU if, as a result of an acquisition or disposition of an interest in a partnership or DE holding a 987 QBU, the asset or liability is not reflected on the books and records of the 987 QBU. Examples illustrate how this rule could potentially cause the recognition of gain or loss. (a) Prop. Treas. Reg. 1.987-2(c)(9), Example 7 states that X owns 100% of the interests in a disregarded entity (DE1) which conducts a business in a different functional currency from X, and thus is a 987 QBU of X. Y transfers property to DE1 in exchange for a 50% interest in DE1, and as a result DE1 converts into a partnership under Rev. Rul. 99-5, 1999-1 C.B. 434, with X and Y treated as contributing property to the newly-formed partnership. The example states that due to Ys acquisition of a 50 percent interest in DE1, 50 percent of the historic assets and liabilities of the business cease being reflected on the books and records of Xs 987 QBU and are treated as transferred from the QBU to X (and also treated as transferred from Y to Ys 987 QBU). Thus, X likely will recognize gain or loss merely because another person makes a contribution to DE1. This rule seemingly violates 721(a), which states that no gain or loss is recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership (emphasis provided). Prop. Treas. Reg. 1.987-2(c)(9), Example 5 describes a partnership that is held 50-50 by X and Y. The partnership holds a 987 QBU and all of its assets are used in the business of the QBU. A new partner, Z, contributes capital to the partnership in exchange for a 20 percent interest. The cash contributed by Z is not used by the 987 QBU. The Example states that 10 percent of the QBUs assets and liabilities cease being reflected on Xs and Ys QBUs and therefore are treated as transferred to X and Y. The result, again, is in conflict with 721(a). The Example does not state the what the result would be if the cash contributed by Z were used in the QBUs business.
(b)
I.
Foreign Taxes 1. A partnership is treated as a conduit for foreign tax credit purposes, with each partner deemed to incur its distributive share of taxes
paid or accrued by the partnership. See 702(a)(6) (stating that each partner shall take into account separately its distributive share of the partnerships creditable foreign income taxes described in 901). A partner's distributive share of the partnerships income generally is treated as income in a separate category determined at the partnership level. Thus, the income should be general basket to the extent that the partnership is engaged in the active conduct of a trade or business. Treas. Reg. 1.904-5(h)(1). (This look through rule does not apply in respect of any limited partner or corporate general partner that owns less than 10% of the value in a partnership, in which case the partners distributive share of the partnerships income is passive basket income. Treas. Reg. 1.904-5(h)(2)). 2. Allocation of Foreign Taxes (a) In October 2006 the Service issued final regulations addressing the allocation by a partnership of creditable foreign taxes. These regulations provide for a safe harbor under which allocations of foreign tax expenditures will be respected. Unlike the allocation of income, gain, deduction, and loss the capital account maintenance provisions do not call for a partners capital account to be adjusted by the allocation of a partnerships tax credits, including foreign tax credits. Treas. Reg. 1.704-1(b)(2)(iv)(b). See also Treas. Reg. 1.704-1(b)(4)(ii). Therefore, allocations of tax credits cannot have economic effect. Accordingly, the final regulations state that tax credits must be allocated in accordance with the partners respective interests in the partnership. Treas. Reg. 1.704-1(b)(4)(viii)(a). The regulations state that an allocation of creditable foreign tax expenditure (CFTE) will be deemed to be in accordance with the partners interests in the partnership (i.e., will satisfy the safe harbor) if (i) the CFTE is allocated (whether or not pursuant to an express provision in the partnership agreement) and reported on the partnership return in proportion to the distributive shares of income to which the CFTE relates; and
(b)
(c)
(ii)
Allocations of all other partnership items that, in the aggregate, have a material effect on the amount of CFTEs allocated to a partner are valid. Treas. Reg. 1.704-1(b)(4)(viii)(a)(1) and (2).
(d)
Comments on the Safe Harbor (i) The final regulations remove the requirement in the temporary regulations that to qualify for the safe harbor, the partnership must maintain capital accounts in accordance with Treas. Reg. 1.7041(b)(2)(iv). This is helpful in the international context, where the maintenance of capital account often is not necessary and could add undesired complication to the deal. See discussion of this issue at III.B.6 of this outline. The preamble states that only in unusual circumstances (such as where CFTEs are deducted and not credited) will allocations that fail to satisfy the safe harbor be in accordance with the partners interest in the partnership. Therefore, for practical purposes, the safe harbor appears to be the rule. Special allocations of CFTEs are premitted provided that the specially allocated CFTEs are allocated in the same proportion as the income to which the CFTEs relate. The requirement to allocate CFTEs in accordance with net income could produce distortions where the partners economic deal is to share expenses in a ratio different from the ratio in which they end up sharing net income (for example, in the case of a gross income allocation). (A) Treas. Reg. 1.704-1(b)(5), Example 25, describes partnership between A and B where all items are allocated 50/50, with the single exception being that the first $100K of gross income each year is allocated to A as a return on excess capital contributed by A. The example states that in 2007 the partnership earns $300K of gross income, has $100K of deductible expense, and pays
(ii)
(iii)
(iv)
$40K of foreign tax. Accordingly, A is allocated $150K of the partnerships pretax income and B is allocated $50K of the partnerships pretax income. Because all partnership items are allocated equally (except for the gross income allocation), A and B are each allocated $20K of CFTE. The example states that the CFTEs must be reallocated in the same ratio as the partnerships net income, or $30K to A and $10K to B. (B) The example further states that if the reallocation of CFTEs causes the partners capital accounts not to reflect their economic arrangement, the partners may need to reallocate other partnership items to ensure that the tax consequences of the partnerships allocations are consistent with the economic arrangement over the term of the partnership. It states that the Service will not reallocate other partnership items after the reallocation of CFTEs. This seems to be an example of an antiabuse rule having an overinclusive, and unwarranted, effect, particularly on joint ventures between unrelated partners. Assuming A and B in the example are unrelated and their deal motivated by business considerations, foreign tax expenses should be allocated in the same proportion as all other partnership expenses. The result mandated by the regulations causes one partner (A, in the example) to be allocated more foreign taxes (and more foreign tax credits) than A bears the burden of. If A were a U.S. person, A would reap a windfall. If B were a U.S. person, B would suffer a needless detriment. The example also states that the result would be the same if the preferred gross income allocation wee a 707(c) guaranteed payment.
(C)
(D)
(d)
A creditable foreign tax expenditure is defined as a foreign tax paid or accrued by a partnership that is eligible for a credit under section 901(a) or an applicable U.S. income tax treaty. A foreign tax is a CFTE without regard to whether a partner receiving an allocation of such foreign tax elects to claim a credit for such tax. Foreign taxes paid or accrued by a partner with respect to a distributive share of partnership income, and foreign taxes deemed paid under section 902 or 960 are not taxes paid or accrued by a partnership and, therefore, are not CFTEs subject to the rules of this section. Treas. Reg. 1.704-1(b)(4)(viii)(b). A CFTE category is a category of net income (or loss) attributable to one or more activities of the partnership. Net income (or loss) from all the partnership's activities is included in a single CFTE category unless the allocation of net income (or loss) from one or more activities differs from the allocation of net income (or loss) from other activities, in which case income from each activity or group of activities that is subject to a different allocation is treated as net income (or loss) in a separate CFTE category. Treas. Reg. 1.704-1(b)(4)(viii)(c)(2)(i). Thus, if a partnership agreement does not have special allocations, then the CFTE allocation rules will not be relevant. For example, a foreign partnership which is treated as a corporation for local law purposes likely will not need to be concerned with these allocation rules. (i) Different allocations of net income (or loss) generally will result from provisions of the partnership agreement providing for different sharing ratios for net income (or loss) from separate activities. See Treas. Reg. 1.704-1(b)(5), Example 21. Different allocations of net income (or loss) from separate activities generally will also result if any partnership item is shared in a different ratio than any other partnership item. A guaranteed payment described Treas Reg. 1.7041(b)(4)(viii)(c)(3)(ii), gross income allocation, or other preferential allocation will result in different allocations of net income (or loss) from separate activities only if the amount of the payment or the allocation is determined by reference to income from less than all of the partnership's activities. A partnership item does not include any item that is
(e)
excluded from income attributable to an activity pursuant to the second sentence of Treas. Reg. 1.704-1(b)(4)(viii)(c)(3)(ii) (relating to allocations or payments that result in a deduction under foreign law). (ii) Whether a partnership has one or more activities, and the scope of each activity, is determined in a reasonable manner taking into account all the facts and circumstances. The principal consideration is whether the proposed determination has the effect of separating CFTEs from the related foreign income. Accordingly, relevant considerations include whether the partnership conducts business in more than one geographic location or through more than one entity or branch, and whether certain types of income are exempt from foreign tax or subject to preferential foreign tax treatment. In addition, income from a divisible part of a single activity shall be treated as income from a separate activity if necessary to prevent separating CFTEs from the related foreign income. The partnership's activities must be determined consistently from year to year absent a material change in facts and circumstances.
(f)
The net income in a CFTE category means the net income for U.S. Federal income tax purposes, determined by taking into account all partnership items attributable to the relevant activity or group of activities, including items of gross income, gain, loss, deduction, and expense and items allocated pursuant to section 704(c) (including reverse 704(c) allocations). Treas. Reg. 1.7041(b)(4)(viii)(c)(3). (i) The items of gross income attributable to an activity is determined in a consistent manner under any reasonable method taking into account all the facts and circumstances. Expenses, losses or other deductions are allocated and apportioned to gross income attributable to an activity in accordance with the rules of Treas. Reg. 1.861-8 and 1.861-8T. Under these rules, if an expense, loss or other deduction is allocated to
(ii)
gross income from more than one activity, such expense, loss or deduction must be apportioned among each such activity using a reasonable method that reflects to a reasonably close extent the factual relationship between the deduction and the gross income from such activities. See Treas. Reg. 1.861-8T(c). For purposes of determining net income in a CFTE category, the partnership's interest expense and research and experimental expenditures described in section 174 may be allocated and apportioned under any reasonable method, including but not limited to the methods prescribed in Treas. Reg. 1.861-9 through 1.861-13T (interest expense) and 1.861-17 (research and experimental expenditures). (iii) For purposes of determining the net income attributable to any activity of a branch, the only items of gross income taken into account are those items of gross income recognized by the branch for U.S. income tax purposes. Income attributable to an activity includes the amount included in a partner's income as a guaranteed payment (within the meaning of section 707(c)) from the partnership to the extent that the guaranteed payment is not deductible by the partnership under foreign law. See Treas. Reg. 1.704-1(b)(5), Example 25(iv). Except for an inter-branch payment, income attributable to an activity does not include an item of partnership income to the extent the allocation of such item of income (or payment thereof) results in a deduction under foreign law. See Treas. Reg. 1.704-1(b)(5), Example 25(iii) and (iv). Income attributable to an activity does not include net income that foreign law would exclude from the foreign tax base as a result of the status of a partner. See Treas. Reg. 1.704-1(b)(5), Example 27.
(iv)
(v)
(vi)
(g)
Distributive share of income means the net income from each CFTE category, that is allocated to a partner. Treas. Reg. 1.704-1(b)(4)(viii)(c)(4).
(i)
A guaranteed payment is treated as a distributive share of income to the extent that the guaranteed payment is treated as income attributable to an activity pursuant. See Treas. Reg. 1.704-1(b)(5), Example 25(iv). If more than one partner receives positive income allocations (income in excess of expenses) from a CFTE category, which in the aggregate exceed the total net income in the CFTE category, then such partner's distributive share of income from the CFTE category equals the partner's positive income allocation from the CFTE category, divided by the aggregate positive income allocations from the CFTE category, multiplied by the net income in the CFTE category.
(ii)
(h)
If a CFTE is allocated or apportioned to a CFTE category that does not have net income for the year in which the foreign tax is paid or accrued, the following rules apply. Treas. Reg. 1.704-1(b)(4)(viii)(c)(5). (i) The CFTE is deemed to relate to the aggregate of the net income (disregarding net losses) recognized by the partnership in that CFTE category in each of the three preceding taxable years, and allocated in proportion to allocation of the aggregate net income for the such prior three-year period. If the partnership does not have net income in the applicable CFTE category in either the current year or any of the previous three taxable years, the CFTE must be allocated in the same proportion that the partnership reasonably expects to allocate the aggregate net income (disregarding net losses) in the CFTE category for the succeeding three taxable years. If the partnership does not reasonably expect to have net income in the CFTE category for the succeeding three years and the partnership has net income in one or more other CFTE categories for the year in which the foreign tax is paid or accrued, the CFTE is deemed to relate to such other net
(ii)
(iii)
income and must be allocated in proportion to the allocations of such other net income. (iv) If any CFTE is not allocated pursuant to the above rules, then the CFTE must be allocated in proportion to the partners' outstanding capital contributions.
(i)
CFTEs are allocated and apportioned to CFTE categories in accordance with the principles of Treas. Reg. 1.904-6. Treas. Reg. 1.704-1(b)(4)(viii)(d). See also Treas. Reg. 1.704-1(b)(5), Example 20. Under these principles, a CFTE is related to income in a CFTE category if the income is included in the base upon which the foreign tax is imposed. In accordance with Treas. Reg. 1.9046(a)(1)(ii) as modified herein, if the foreign tax base includes income in more than one CFTE category, the CFTEs are apportioned among the CFTE categories based on the relative amounts of taxable income computed under foreign law in each CFTE category. The rules in 1.9046(a)(1)(ii) are modified as follows: (i) The related party interest expense rule in Treas. Reg. 1.904-6(a)(1)(ii) does not apply in determining the amount of taxable income computed under foreign law in a CFTE category. If foreign law does not provide for the direct allocation or apportionment of expenses, losses or other deductions allowed under foreign law to a CFTE category of income, then such expenses, losses or other deductions must be allocated and apportioned to gross income as determined under foreign law in a manner that is consistent with the allocation and apportionment of such items for purposes of determining the net income in the CFTE categories for U.S. tax purposes pursuant to Treas. Reg. 1.904-1(b)(4)(viii)(c)(3). A foreign tax imposed on an item that would be income under U.S. tax principles in another year (a timing difference) is allocated to the CFTE category that would include the income if the income were recognized for U.S. tax purposes in the year in which the foreign tax is imposed. A foreign tax
(ii)
(iii)
imposed on an item that would not constitute income under U.S. tax principles in any year (a base difference) is allocated to the CFTE category that includes the partnership items attributable to the activity with respect to which the foreign tax is imposed. See Treas. Reg. 1.704-1(b)(5), Example 23. (iv) The following special rules apply if a branch of the partnership is required to include in income under foreign law a payment it receives from another branch of the partnership. The foreign tax imposed on such payments ("inter- branch payments") is allocated to the CFTE category that includes the items attributable to the relevant activities of the recipient branch. In cases where the partnership agreement results in more than one CFTE category with respect to activities of the recipient branch, such tax is allocated to the CFTE category that includes the items attributable to the activity to which the inter-branch payment relates. These rules also apply to payments between a partnership and a branch of the partnership. See Treas. Reg. 1.7041(b)(5), Example 24.
(j)
The final regulations are generally effective for partnership taxable years beginning on or after October 19, 2006. Under a transition rule, if a partnership agreement was entered into before April 21, 2004, then the partnership may apply the provisions of Treas. Reg. 1.704-1(b) as if the amendments made by the final regulations had not occurred. If the partnership agreement is materially modified on or after April 21, 2004, transition relief is not longer afforded. A material modification includes any change in ownership of the partnership. The transaction rule does not apply if, as of April 20, 2004, persons that are related to each other (within the meaning of 267(b) and 707(b) collectively have the power to amend the partnership agreement without the consent of an unrelated party. Taxpayers may rely on the final regulations for partnership taxable years beginning on or after April 21, 2004. Treas. Reg. 1.704-1(b)(5) contains a series of examples illustrating the operation of the rules.
(k)
3.
Look Through Treatment For Section 902 Credits. The American Jobs Creation Act of 2004 added 902(c)(7) which states that for purposes of determining eligibility for the indirect foreign tax credit, stock owned, directly or indirectly, by or for a partnership is considered as being owned proportionately by its partners. The Service is given regulatory authority to determine ownership in a partnership where there are special allocations. This enactment is consistent with Rev. Rul. 71-141, 1971-1 C.B. 211, which states that for purposes of 902 a domestic general partnership is treated as an aggregate in measuring its corporate general partners ownership interests in foreign corporations held by the partnership. It also confirms longstanding practice in which aggregate treatment was applied entities other than domestic general partnerships that are treated as partnerships for federal income tax purposes. The American Jobs Creation Act of 2004 amended 901(b)(5) to clarify that a domestic corporation who is a member of a partnership may claim direct foreign tax credits under 901 with respect to its proportionate share of the taxes paid or accrued by a partnership. Technical Taxpayer Rule (a) Treas. Reg. 1.901-2(f)(1), reversing Abbot [sic] Laboratories Intl Co. v. United States, 261 F.2d 940 (7th Cir 1959), sets forth the technical taxpayer rule, which states
The person by whom tax is considered paidis the person on whom foreign law imposes legal liability for such tax
4.
5.
(b)
In the case of an entity that is treated as a partnership for both U.S. and foreign purposes, the partners are typically the technical taxpayers and entitled to 901 credits. In the case of a hybrid entity, the determination of who is the taxpayer is made under U.S. law rather than by classification under foreign statute. See Biddle v. Commissioner, 302 U.S. 573 (1938). Entitlement to credits, however, is subject to the Temp. Treas. Reg. 1.704-1T(b)(1)(ii)(b) partners interest in the partnership standard, discussed above. In August 2006 the Service issued proposed regulations on the technical taxpayer rule in the context of, among other
(c)
(d)
things, reverse hybrids and hybrid entities. The regulations were issued partially in response to the situations where a taxpayer was claiming foreign tax credits on income that the taxpayer did not immediately include for U.S. federal tax purposes. (i) If an entity is a corporation for U.S. tax purposes and a pass-through entity for foreign purposes (a reverse hybrid), tax imposed on the person's share of income from each reverse hybrid and tax imposed by the foreign country on other income of the person, if any, is considered to be imposed on the combined income of the person and each reverse hybrid. Prop. Treas. Reg. 1.901-2(f)(2)(iii). Therefore, foreign tax imposed on the combined income of the person and each reverse hybrid is allocated between the person and the reverse hybrid on a pro rata basis. The term pro rata means in proportion to the portion of the combined income included in the foreign tax base that is attributable to the person's share of income from each reverse hybrid and the portion of the combined income that is attributable to the other income of the person (including income received from a reverse hybrid other than in the owner's capacity as an owner). If the person has a share of income from the reverse hybrid but no other income on which tax is imposed by the foreign country, the entire amount of foreign tax is allocated to and considered paid by the reverse hybrid. If foreign law imposes tax at the entity level on the income of an entity that is treated as a partnership for U.S. income tax purposes (a hybrid partnership), the hybrid partnership is considered to be legally liable for such tax under foreign law. Prop. Treas. Reg. 1.901-2(f)(3). Therefore, the hybrid partnership is considered to pay the tax for U.S. income tax purposes. See Treas. Reg. 1.7041(b)(4)(viii). If the hybrid partnership's U.S. taxable year closes for all partners due to a termination of the partnership under 708 and the regulations thereunder (other than in the case of a termination under section 708(b)(1)(A)) and the foreign taxable year of the partnership does not
(ii)
close, then foreign tax paid or accrued by the partnership with respect to the foreign taxable year that ends with or within the new partnership's first U.S. taxable year is allocated between the terminating partnership and the new partnership. The allocation is made under the principles of Treas. Reg. 1.1502-76(b) based on the respective portions of the taxable income of the partnership (as determined under foreign law) for the foreign taxable year that are attributable to the period ending on and the period ending after the last day of the terminating partnership's U.S. taxable year. The principles of the preceding sentence also apply if the hybrid partnership's U.S. taxable year closes with respect to one or more, but less than all, partners or, except as otherwise provided in section 706(d)(2) or (d)(3) (relating to certain cash basis items of the partnership), there is a change in any partner's interest in the partnership during the partnership's U.S. taxable year. If, as a result of a change in ownership during a hybrid partnership's foreign taxable year, the hybrid partnership becomes a disregarded entity and the entity's foreign taxable year does not close, foreign tax paid or accrued by the disregarded entity with respect to the foreign taxable year is allocated between the hybrid partnership and the owner of the disregarded entity under the principles of Prop. Treas. Reg. 1.901-2(f)(3)(i). (iii) The rules were stated to be effective for foreign taxes paid or accrued during taxable years of the taxpayer beginning on or after January 1, 2007. However the regulations were not completed by the end of 2007. According to Deputy Assistant Treasury Secretary Michael Mundaca, they will not take effect until the tax year beginning after the final regulations are issued. 2007 TNT 209-4.
(e)
Query Treasurys authority to issue regulations in this area. (i) In the two years leading up to the issuance of the proposed regulations, Treasury twice sought, and failed to receive, statutory authority to write regulations addressing the separation of foreign
taxes from related foreign income. Both times the Senate passed bills including Treasurys desired language, but the relevant provisions of the Senate bills did not become law. See 452 of H.R. 4297, the Tax Increase Prevention and Reconciliation Act of 2005 (2005 Act), as amended and passed by the Senate on February 2, 2006, and 661A of S. 1637, Jumpstart Our Business Strength (JOBS) Act, passed by the Senate on May 11, 2004. (ii) In the legislative history of the 2005 Act (enacted on May 17, 2006), the Conference Committee Report makes a cryptic statement in respect of Treasurys regulatory authority in this area. In describing the Senate Bill, which was not enacted, the Conference Report states
This grant of regulatory authority supplements existing Treasury Department authority and thereby provide greater flexibility in addressing a wide range of transactions and structures. Regulations issued pursuant to this authority could, for example, provide for the disallowance of a credit for all or a portion of the foreign taxes, or for the allocation of the foreign taxes among the participants in the transaction in a manner more consistent with the economics of the transaction.
Tax Increase Prevention and Reconciliation Act of 2005, Conference Report to Accompany H.R. 4297 (May 9, 2006), at 264. The Conference Report goes on to state
No inference is intended as to the scope of the Treasury Departments existing regulatory authority to address transactions that involve the inappropriate separation of foreign taxes from the related foreign income.
Id. The Conference Report states that Treasury has existing authority in this area, but it also states the
legislation would have granted Treasury authority that "supplements" its existing authority. Because the legislation didn't pass, Treasury presumably doesn't have this extra authority. Examples of this extra authority, as stated in the report include, authority to disallow credits for all or a portion of the foreign taxes and the authority to allocate foreign taxes among the participants in a transaction in a manner more consistent with the economics of a transaction. The "no inference" language leaves extent of Treasury's current authority somewhat unanswered. But it seems that Treasury can't do whatever it wants. (iii) The technical taxpayer rule and the principles underlying it are longstanding under both judicial decisions and administrative authority. See Biddle, supra; Treas. Reg. 1.901-2(f); Rev. Rul. 72-197, 1972-1 C.B. 215; and Rev. Rul. 58-518, 1958-2 C.B. 381. For a recent Tax Court decision discussing the validity of Treasury Regulations, see Swallows Holding v. Commissioner, 126 T.C. 96 (2006).
(iv)
(f)
Obama Administration Proposal. One of the Obama Administrations proposed international tax reforms would prevent the separation of foreign tax credits and income through a matching rule. This proposal is substantially similar to the 2006 proposed regulations. It would seem that the proposed regulations will not be finalized, at least until final disposition of the proposal through the legislative process, because implementation of this proposal through legislation, rather than through regulations, would count as a revenue raiser
6.
TEFRA Audit Rules and Procedures (a) The TEFRA audit rules and procedures call for a separate audit of the partnership return and the separate administrative and judicial resolution of disputes in respect of partnership items. The TEFRA rules themselves are silent as to whether foreign taxes constitute partnership items. Proposed regulations under 6231 provided that foreign taxes were a partnership item. Prop. Treas. Reg.
301.6231(a)(3)-1(a)(1)(ii). When the regulations were finalized, however, reference to foreign taxes was eliminated. In an FSA the Service expressed the view that whether foreign taxes are a partner item or a partnership item depends on whether, under foreign law, the taxes are imposed on the partners in their individual capacities (partner item) or on the partnership as an entity (partnership item). 1995 FSA Lexis 65 (Oct. 18, 1995). (b) The issue can get more complicated in respect of deemed paid credits claimed by partners. FSA 200144006, supra, describes two domestic partners who own interests in a U.K. entity that made a check-the-box election to be treated as a partnership and received dividends from its foreign subsidiaries. The Service stated that the taxes paid by the subsidiaries are not partnership items, as the partnership itself did not pay or accrue the taxes. Further, according to the Service, the amount of the foreign subsidiaries earnings and foreign income taxes, and whether the taxes paid by the foreign subsidiaries are creditable taxes in the first instance, are not determined at the partnership level, and therefore are not partnership items. However, the Service stated that certain items relevant to the issue require a partnership-level determination. It stated that the 904 basket of the dividends received by the partnership is a partnership item since classification under 904 is made at the partnership level. In addition, the Service stated that partners entitlement to the foreign tax credits in the amount claimed was dependent, in part, on the partners establishing ownership of the requisite voting stock in the foreign subsidiaries, and to the extent the partnerships stock ownership in the foreign subsidiaries was relevant to this determination, the amount of the deemed paid credit was an affected item. Presumably the Service based this conclusion on Treas. Reg. 301.6231(a)(3)-1(a)(1)(vi), which provides that a partnership item includes amounts in respect of the partnerships assets, investments, transactions, and operations necessary to enable the partnership or the partners to determine certain items; however one of these items is not whether and the extent to which partners may claim indirect foreign tax credits. Cf. Olsen-Smith, Ltd. et. al. v. Commissioner, T.C. Memo 2005-174 (the determination of the identity of indirect partners of a
(c)
partnership is not a partnership item that a court may determine in a partnership-level proceeding). (d) Under such a bifurcated approach, it would appear that the resolution of disputes involving 902 credits could require the resolution of a partnership-level audit followed by the resolution of a partner-level audit.
7.
TAM on Foreign Tax Credit, Partnership Anti-Abuse, Economic Substance (a) TAM 200807015 denies a taxpayer's claim for foreign tax credits under section 901 for U.K. tax payments on a subsidiary's income on a number of grounds, including that the U.K. tax on the subsidiary's income was not minimized and that the transactions generating the FTCs lacked economic substance. A number of partnership issues were involved. Facts (i) UK Parent is a U.K. corporation that wholly owns UK Sub1 and UK Sub2. UK Sub1 and UK Sub2 are also U.K. corporations. UK Sub1 formed issuer with a capital contribution. UK Sub also loaned a certain amount to Issuer. Taxpayers take the position that Issuer is a partnership for U.S. tax purposes. US Corp is a domestic corporation that wholly owns US Sub, also a domestic corporation. US Corp and US Sub are members of US Group. US Sub used an amount contributed to it by US Corp to purchase non-convertible securities (the "Securities") issued by Issuer. UK Parent and Issuer treated the Securities as debt for U.K. tax purposes. Taxpayers take the position that the Securities are equity interests in Issuer (i.e., partnership interests) for U.S. tax purposes. Issuer then capitalized Subsidiary and made a loan to Subsidiary. Subsidiary is a U.K. entity that is treated as a corporation for U.K. purposes. An election was made to treat Subsidiary as a disregarded entity for U.S. tax purposes.
(b)
(ii)
(iii)
(iv)
Subsidiary, in turn, loaned the entire amount of funds it received from Issuer to UK Parent. UK Parent deducted the interest paid to Subsidiary. Subsidiary was subject to UK tax on its income, including the interest income received from UK Parent. Issuer was not taxable on distributions it received from Subsidiary since it had a corresponding interest deduction on distributions it made on the Securities held by US Sub (the Securities were debt for UK purposes and equity for US purposes). Accordingly Issuer has losses for UK tax purposes, which it surrendered to UK Parent for purposes of the U.K. group relief rules.
(v)
(c)
Rulings (i) The Service stated that payments to the U.K. in respect of Subsidiary's income are noncompulsory payments under 1.901-2(e)(5) to the extent those payments exceed the amount of U.K. tax that would have been due if Issuer had surrendered its losses to Subsidiary. The noncompulsory payments are therefore not taxes paid for purposes of section 901, and Taxpayers are not eligible to claim credits under section 901 for such payments. The Service explained that both Issuer and Subsidiary were part of the UK Parent group relief group for U.K. tax purposes. Under the group relief provisions, any two members of a group can agree to invoke group relief. Relief is elective between members and is effectively a contract between the surrendering company and the claimant company. Thus, under the U.K. group relief rules, Issuer could have elected to surrender its losses to Subsidiary and Subsidiary could have elected to claim those losses. This would have reduced the amount of Subsidiary's taxable income for U.K. tax purposes and, thus, the amount of U.K. tax due with respect to such income. Issuer instead elected to surrender those losses to UK Parent. Therefore, Issuer failed to apply the substantive and procedural provisions
(ii)
of U.K. law in a manner that minimized its U.K. tax obligations. (iii) Taxpayer argued that Subsidiary, and not issuer, is the "taxpayer" under Treas. Reg. 1.901-2(f) and, thus, the taxpayer for purposes of Treas. Reg. 1.901-2(e)(5), and that Subsidiary did not have the unilateral power to reduce its U.K. taxes by using Issuer's losses. The Service cited Biddle in its defense. It stated, Taxpayers misinterpret the role of foreign law under Treas. Reg. 1.901-2(f). Foreign law is relevant in determining which person, among several, is the person with "legal liability" and, thus, the taxpayer for foreign tax credit purposes. However, the meanings of the terms "legal liability" and "person" are determined under U.S. tax principles, not under foreign law. Cf. Biddle v. Commissioner, 302 U.S. 573, 578 (1938) (applying U.S. tax principles to determine whether a U.K. corporation or its shareholder was the payor of certain U.K. taxes for U.S. foreign tax credit purposes). The Service stated that alternatively, the Securities are more like debt than equity for U.S. tax purposes. Therefore, Taxpayers are not entitled to foreign tax credits for U.K. taxes paid with respect to Subsidiary's income. In this regard--the Service stated that the Instrument negated any possibility of meaningful entrepreneurial risk; the Holders had the right to compel payment and recoup the principal and any accrued, but unpaid, yield payments; issuer liabilities were the only claims to which the Securities were subordinate, and according to the Service, the subordination to Issuer liabilities was strictly illusory, since, among other things Issuer covenanted that it would incur no liabilities other than certain limited permitted liabilities; the Service cited lack of participation in management rights; the amounts advances were not used to finance an entrepreneurial venture; the financial analysis surrounding the advances was in the nature of a debt analysis; the generation of foreign tax credits was indicative of the parties intent.
(iv)
(v)
Alternatively, the service stated, Issuer and Subsidiary are mere conduits and the substance of the Transaction is a loan from US Sub (and, subsequently, Transferee) to UK Parent. Therefore, for U.S. tax purposes, US Sub and Transferee are considered to receive interest income from UK Parent in the amount of the distributions they received from Issuer. Taxpayers are not entitled to claim credits pursuant to sections 702(a) and 901 for the U.K. taxes imposed in respect of Subsidiary's income. An alternate theory was that the anti-abuse rule of Treas. Reg. 1.701-2(a) applies to prevent Taxpayers from claiming foreign tax credits. Issuer conducted no business activity, but simply contributed the majority (and lent a small portion) of its capital to Subsidiary. Subsidiary, in turn, lent the entire sum to UK Parent. The Service rejected the taxpayers argument that it entered into the transaction to reduce credit risk and to increase pretax profit. Additionally, the Service stated that the use of Issuer and Subsidiary lacked economic substance because it served no legitimate non-tax purpose and had no objective economic substance. Therefore, the use of those entities and the foreign tax credits must be disregarded.
(vi)
(vii)
J.
Allocation and Apportionment of Expenses 1. When a domestic partner makes a loan to its foreign partnership, the domestic partner could be required to apportion an inordinate amount of interest expense to foreign source income. (a) A domestic taxpayer must apportion its expenses to U.S. and foreign sources. Expenses that are treated as foreign source reduce the taxpayers foreign source income, and thus limit its ability to claim foreign tax credits. As a general matter, interest expense is apportioned by reference to all of the taxpayers assets and income producing activities. Treas. Reg. 1.861-9T(a). Domestic corporations are required to apportion their interest expense in the same ratio as their U.S source income-producing
assets bear to their foreign source income-producing assets, and generally do so by reference to the assets bases. Treas. Reg. 1.861-9T(f)(1) and 1.861-9T(g). Taxpayers can also use fair market value as the measure. (b) A domestic corporation valuing assets by reference to their bases that makes a loan to a foreign partnership in which it is a partner potentially must double count foreign source income-producing assets in apportioning its interest expense. When a domestic partner makes a loan to a foreign partnership the loan is reflected in basis twice(1) the partner has a basis in its receivable owing from the partnership, and (2) the partners share of the partnerships liability is treated as a contribution of money by the partner to the partnership, thereby increasing the partners basis in the partnership. 752(a). This double counting of the same foreign source income-producing asset will cause the partners interest apportionment to be inordinately skewed to foreign source income. This is not the correct result from a policy perspective. The regulations state that the allocation and apportionment of interest is based on the approach that, in general, money is fungible and that interest expense is attributable to all activities and property regardless of any specific purpose for incurring an obligation on which interest is paid. Treas. Reg. 1.861-9T(a). Thus, undue weight should not be given to any particular asset or activity. An obvious fix would be to exclude either the partners basis in the receivable or the extra basis it receives in its partnership interest by virtue of 752(a). See 1996 FSA Lexis 177 (June 6, 1996), which seems to indicate that the partners receivables owing from the partnership are not included in the asset base for apportioning the interest expense of the partner.
(c)
2.
In TAM 200545045 (July 21, 2005), the Service ruled that for purposes of apportioning partner-level interest expense under the fair market value method pursuant to Treas. Reg. 1.8619T(e)(2) and 1.861-9T(h)(1)(ii), the taxpayer must include its proportionate share of the partnerships assets rather than its net equity interest in the partnership, i.e. an aggregate approach must be applied.
(a)
Taxpayer directly and indirectly holds 100% interests in partnerships whose sole activity is to manage and hold the stock of lower-tier foreign corporations. Several of the partnerships incur interest expense on debt owned to a member of the taxpayers affiliated group. Taxpayer also incurs interest expense. Taxpayer apportioned its distributive share of partnership interest expense, based on the combined fair market values of the gross assets of the Taxpayers U.S. consolidated group, including the groups proportionate share (100%) of the gross assets of the partnerships. In apportioning the interest expense that it directly incurred, however, the Taxpayer did not take into account the gross assets of the partnerships, but rather took into account its net equity interests in the partnerships. Treas. Reg. 1.861-9T(e)(2) states that a corporate partner whose direct and/or indirect in a partnership is 10 percent or more must apportion its distributive share of partnership interest expense by reference to the partners assets, including the partners pro rata share of partnership assets, i.e. an aggregate approach applies. This regulation, however, does not address whether an aggregate or entity approach applies in apportioning partner-level interest expense for such a corporate partner. The Service stated that the more logical and consistent reading of Treas. Reg. 1.861-9T(e) is to apply an aggregate approach for allocations of partnership-level interest expense. It reasoned that this approach is consistent with the premise underlying the FMV methodology, that interest expense is apportioned on the basis of all of the taxpayers income-generating assets. It stated that the entity approach used for less-than-tenpercent corporate partners is simply a rule of administrative convenience. The TAM reports the Taxpayer as asserting that interest is deemed fungible with respect to income of the taxpayer, and that this term does not include a partnership held by the taxpayer. Thus, according to the Taxpayer, an entity approach can apply in valuing a partnership. The Service did not agree.
(b)
(c)
(d)
(e)
3.
Treas. Reg. 1.861-12T(c), revised in April 2006, states that an affiliated group that uses the tax book value method in apportioning its interest expense must adjust the basis of stock in any 10 percent owned corporation held by members of the group to reflect the members pro rata share of the corporations E&P. The regulation was revised to clarify that it applies both to stock of a 10 percent owned corporation owned directly by members of the group and also to stock held indirectly through a partnership or other pass through entity. The revision is effective for taxable years beginning after April 25, 2006. Allocation and Apportionment of R&E Expense. In TAM 200615034 (Feb. 3, 2005), the Service ruled the Taxpayer, a foreign corporation that was a partner in a partnership with ECI, could reduce its distributive share of the ECI by the Taxpayers 174 R&E expenses under the allocation and apportionment rules of Treas Reg. 1.861-17. The Service applied an aggregate approach to partnerships in the ruling. (a) The TAM describes Taxpayer, a foreign corporation that conducts R&E, manufacturing and sales activities. Taxpayer was a partner in a partnership that manufactured products using IP licensed from Taxpayer. The partnership earned ECI. The taxpayer allocated its R&E expenses to all its income in certain SIC codes, and apportioned these expenses under the gross income method of Treas. Reg. 1.861-17(d). The IRS Exam team challenged the Taxpayers allocation of R&E expenses to any portion of its ECI derived from its distributive share of partnership income. The National Office stated that it did not agree with Exam that Treas. Reg 1.861-17 requires the entity approach to be applied. The National Office stated that the more appropriate characterization is to treat the Taxpayer as engaged in the activities of the Partnership and to apply the allocation and apportionment rules at the partner (Taxpayer) level between gross ECI and the residual grouping of income. The National Office cited 875(1) (treating a foreign corporation as being engaged in a U.S. trade or business if it is a partner in a partnership that is so engaged). The National Office also cited Treas. Reg. 1.861-17(f)(1) as providing analogous authority for an aggregate approach.
4.
(b)
(c)
K.
Challenges to Partnership Allocations 1. The preamble to the temporary regulations on the allocation of foreign taxes (April 2004) discusses forthcoming guidance in respect of the Treas. Reg. 1.704-1(b)(2)(iii) substantiality prong of the substantial economic effect requirement. The preamble states that the IRS and Treasury have become aware that some partnerships are taking the position that, in determining if the economic effect of a partnership allocation is substantial, they need not consider any tax consequences to an owner of the partner that result from the allocation. The preamble states that the IRS and Treasury believe that such a position is inconsistent with the policies underlying the substantial economic effect rules, because it would allow a partnership to make tax-advantaged allocations if the tax advantages of the allocations were to accrue to an owner of a partner, rather than to a partner itself. Treas. Reg. 1.704-1(b)(2)(iii)(d) states that in determining the after-tax economic benefit or detriment to any partner that is a look-through entity, the tax consequences that result from the interaction of the allocation with the tax attributes of any person that owns an interest in such a partner, whether directly or indirectly through one or more look-through entities, must be taken into account, and, in determining the after-tax economic benefit or detriment to any partner that is a member of a consolidated group (within the meaning of Treas Reg. 1.1502-1(h)), the tax consequences that result from the interaction of the allocation with the tax attributes of the consolidated group and with the tax attributes of another member with respect to a separate return year must be taken into account. (a) A look-through entity is defined as a partnership, an S corporation, a trust, an entity that is disregarded for federal tax purposes, and a CFC but only with respect to allocations of items that enter into the corporation's computation of subpart F income or would enter into that computation if such items were allocated to the corporation (collectively, subpart F items) and only by taking into account the tax attributes of a person that is a United States shareholder of the CFC the amount of whose inclusions of gross income under 951(a) are affected by the partnership's allocations of subpart F items (or would be affected if such items were allocated to the corporation). Treas. Reg. 1.704-1(b)(2)(iii)(d)(2).
2.
(b)
Treas. Reg. 1.704-1(b)(5), Example 29 describes PRS, a partnership with three partners, A, B, and C. A is a corporation that is a member of a consolidated group. B is an S corporation that is wholly owned by D, an individual. C is a partnership with two partners, E, an individual, and F, a corporation that is member of a consolidated group. The example states that in determining the after-tax economic benefit or detriment of an allocation to A, the tax consequences that result from the interaction of the allocation to A with the tax attributes of the consolidated group in which A is a member must be taken into account; in determining the after-tax economic benefit or detriment of an allocation to B, the tax consequences that result from the interaction of the allocation with the tax attributes of D must be taken into account; in determining the after-tax economic benefit or detriment of an allocation to C, the tax consequences that result from the interaction of the allocation with the tax attributes of E and the consolidated group in which F is a member must be taken into account.
3.
Treas. Reg. 1.704-1(b)(5), Example 30 describes A, a CFC, and B a foreign corporation that is not a CFC, which form partnership AB. B is owned by a domestic corporation. C is owned by a foreign individual. A and B each contributed 50% of ABs capital and agree to share ABs bottom-line income equally. There is strong likelihood that AB will realize equal amounts of subpart F income and non-subpart F income. A and B agree that B will be allocated all of ABs subpart F income to the extent of its 50% share of ABs bottom-line income. The example states that the allocations have economic effect but are not substantial. The substantiality test is failed because there was a strong likelihood at the time the allocations became part of the partnership agreement that the capital accounts of A and B would not differ substantially if the special allocation had not been made and the total tax liability from ABs income (taking into account the tax attributes of the allocations to As owner) would be reduced as a result of the special allocations.
L.
Section 752 Regulations on Disregarded Entities 1. Treas. Reg. 1.752-2(k)(1) states that in determining the extent to which a partner bears the economic risk of loss for a partnership liability, an obligation of a business entity that is disregarded as an entity separate from its owner under 856(i) or 1361(b)(3) or Treas. Reg. 301.7701-1 through 301.7701-3 is taken into
account only to the extent of the net value of the disregarded entity as of the allocation date (described below) that is allocated to the partnership liability. These rules do not apply to an obligation of a disregarded entity to the extent that the owner of the disregarded entity otherwise is required to make a payment (that satisfies the requirements of Treas. Reg. 1.752-2(b)(1)) with respect to such obligation of the disregarded entity. 2. Treas. Reg. 1.752-2(k)(2)(i) states that the net value of a disregarded entity equals the fair market value of all assets owned by the entity that may be subject to creditors' claims under local law, including the entity's enforceable rights to contributions from its owner and the FMV of an interest in any partnership other than the partnership for which net value is being determined, but excluding the entity's interest in the partnership for which the net value is being determined and the net FMV of property pledged to secure a partnership liability; less obligations of the disregarded entity that do not constitute Treas. Reg. 1.752-2(b)(1) payment obligations of the disregarded entity. If a partnership interest is held by a disregarded entity, and the partnership has or incurs a liability, all or a portion may be allocable to the owner of the disregarded entity, the disregarded entitys net value must be initially determined on the allocation date. Also, if one or more valuation events occur during the partnership taxable year, then the net value of the disregarded entity is generally determined on the allocation date. Treas. Reg. 1.752-2(k)(2)(ii). Treas. Reg. 1.752-2(k)(2)(iii) states that a valuation event is (a) A more than de minimis contribution to a disregarded entity of property other than property pledged to secure a partnership liability under Treas. Reg. 1.752-2(h)(1), unless the contribution is followed immediately by a contribution of equal net value by the disregarded entity to the partnership for which the net value of the disregarded entity otherwise would be determined, taking into account any obligations assumed or taken subject to in connection with such contributions. A more than de minimis distribution from a disregarded entity of property other than property pledged to secure a partnership liability under Treas. Reg. 1.752-2(h)(1), unless the distribution immediately follows a distribution of
3.
4.
(b)
equal net value to the disregarded entity by the partnership for which the net value of the disregarded entity otherwise would be determined, taking into account any obligations assumed or taken subject to in connection with such distributions. (c) A change in the legally enforceable obligation of the owner of the disregarded entity to make contributions to the disregarded entity. The incurrence, refinancing, or assumption of an obligation of the disregarded entity that does not constitute a Treas. Reg. 1.752-2(b)(1) payment obligation of the disregarded entity. The sale or exchange of a non-de minimis asset of the disregarded entity (in a transaction that is not in the ordinary course of business). In this case, the net value of the disregarded entity may be adjusted only to reflect the difference, if any, between the fair market value of the asset at the time of the sale or exchange and the fair market value of the asset when the net value of the disregarded entity was last determined. The adjusted net value is taken into account for purposes of Treas. Reg. 1.752-2(k)(1) as of the allocation date.
(d)
(e)
5.
Treas. Reg. 1.752-2(k)(2)(iv) states that the allocation date is the earlier of (a) The first date occurring on or after the date on which the requirement to determine the net value of a disregarded entity arises under Treas. Reg. 1.752-2(k)(2)(ii)(A) or (B) on which the partnership otherwise determines a partners share of partnership liabilities under Treas. Reg. 1.7051(a) or 1.752-4(d); or The end of the partnerships taxable year in which the requirement to determine the net value of a disregarded entity arises under Treas. Reg. 1.752-2(k)(2)(ii)(A) or (B)
(b)
6.
If one or more disregarded entities have Treas. Reg. 1.7522(b)(1) payment obligations with respect to one or more liabilities of a partnership, the partnership must allocate the net value of each disregarded entity among partnership liabilities in a reasonable and
consistent manner, taking into account the relative priorities of those liabilities. Treas. Reg. 1.752-2(k)(3). 7. The net value of a disregarded entity is determined by taking into account a subsequent reduction in the net value of the disregarded entity if, at the time the net value of the disregarded entity is determined, it is anticipated that the net value of the disregarded entity will subsequently be reduced and the reduction is part of a plan that has as one of its principal purposes creating the appearance that a partner bears the economic risk of loss for a partnership liability. Treas. Reg. 1.752-2(k)(4). A partner that may be treated as bearing the economic risk of loss for a partnership liability based upon a Treas. Reg. 1.752-2(b)(1) payment obligation of a disregarded entity must provide information to the partnership as to the entity's tax classification and the net value of the disregarded entity that is appropriately allocable to the partnership's liabilities on a timely basis. Treas. Reg. 1.752-2(k)(5). The regulations are generally effective for liabilities incurred or assumed by a partnership on or after October 11, 2006.
8.
9. M.
Sale of CFC by a Foreign PartnershipSection 1248 1. Section 1248(a) states in general that if a U.S. person sells stock in a foreign corporation that is or has been a CFC and the U.S. person is a United States shareholder (as defined in 951(b)) of the CFC, then the U.S. persons capital gain is recharacterized as ordinary income to the extent of the U.S. persons share of the CFCs earnings and profits. Section 1248 generally provides tax benefits to the selling U.S. person, since it recharacterizes what often is U.S. source, passive basket capital gain into what often is foreign source, general basket ordinary income, which can carry foreign tax credits. Section 1248 can be disadvantageous to a U.S. person, if for example, the U.S. person has capital losses against which capital gain could be offset. Under Treas. Reg. 1.1248-1(a)(4) if a foreign partnership sells or exchanges stock of a corporation, the partners are treated as having actually sold their proportionate share of the stock of the corporation. The Preamble states that Treasury and the Service regard this rule as a clarification of existing law, but acknowledge
2.
3.
4.
that some practitioners have expressed the view that prior law was not entirely clear. See Rev. Rul. 69-124, 1969-1 C.B. 203. Accordingly, taxpayers are permitted to apply Treas. Reg. 1.1248-1(a)(4) to open years provided the taxpayer consistently applies the rule in all such years. 5. The Preamble states that Treas. Reg. 1.1248-1(a)(4) should not be interpreted as applying to the sale by a partner of its interest in a partnership holding the stock of a corporation. According to the Preamble, such a reading would be contrary to 1248(g)(2)(B), which provides that 1248 will not apply if another provision of the Code treats an amount as ordinary income. Section 751 provides that an amount received by a partner for its partnership interest is treated as ordinary income to the extent attributable to stock in a foreign corporation under 1248.
N.
Section 894 1. In LTR 200420012 (Jan. 30, 2004), the Service, reconsidering a prior ruling, stated that German partners in a partnership with a New York office are taxable on their distributive shares of the partnerships U.S. source income, even if such partners do not perform services in the U.S. The ruling describes a German law firm with a New York office. A U.S.-resident partner (X) works in the New York office and performs services solely from the U.S. The partnership agreement allocates all of the profits from the New York office to X. Germany does not tax X because he does not perform services from Germany. In a prior ruling the Service stated that German residents who are partners in the partnership are not taxable in the U.S. on their distributive shares of partnership income because those partners did not perform services in the U.S. The Service reconsidered the prior ruling, and now believes that the German residents are taxable in the U.S. on their distributive shares of partnership income, if any, attributable to Xs performance of services in the U.S. without regard to whether the German partners perform services in the U.S. Article 14(1) of the U.S.-Germany Treaty states that income derived by an individual from personal services may be taxable in the state of source if attributable to a fixed base regularly available
2.
3.
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5.
to the individual in that state for the purpose of performing his activities. In the ruling, the Service cited the Technical Explanation of Art. 14 which states that the it encompasses all personal services performed by an individual for his own account, whether as a sole proprietor or a partner, when the individual receives the income from, and bears the risk associated with, the services. Thus, according to the Service, Art. 14 applies to income derived from the performance of independent personal services by partners in a service partnership. O. Exit Strategies 1. The sale of a partnership interest is treated as the sale of a capital asset. 741. The only exception in this regard is 751 which provides that the amount received by the transferor of a partnership interest is not treated as an amount received from the sale or exchange of a capital asset, and thus is treated as ordinary income, to the extent that it is attributable to unrealized receivables of the partnership or appreciated inventory (collectively referred to as " 751 property). If a partnership liquidates, and the partner receives money or money equivalents in excess of basis, the excess is similarly treated as gain from the sale or exchange of a capital asset. 731(a)(1). The American Jobs Creation Act of 2004 provides for aggregate treatment in determining the character of the gain in the case of partners who own at least 25 percent of the capital or profits interest in the partnership. In other cases, gain is passive basket income. 904(d)(1)(A); 904(d)(2)(A)(i); and 954(c)(1)(B)(ii); 954(c)(4). The source likely would be U.S. source income if the seller is a U.S. resident. 865(a). However, 865(e)(1) states that under certain circumstances income from the sale of personal property is foreign source income if the U.S. resident maintains an office or other fixed place of business in a foreign country. This rule only applies if income tax equal to at least 10 percent of the income from the sale is actually paid to a foreign country. (a) In LTR 9142032 (July 23, 1991) the Service ruled that income derived by a U.S. limited partner from the sale of an interest in a foreign partnership was foreign source since the income was attributable to the partnerships foreign
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office. The Service cited Donroy v. United States, 301 F. 2d 200 (9th Cir. 1962), and Unger v. Commissioner, 936 F. 2d 1316 (DC Cir. 1991), which hold generally that the office or fixed place of business of a partnership is considered to be the office or fixed place of business of each of its partners. The foreign source nature of the income was conditioned on the partner actually paying foreign tax at a 10 percent effective rate on its gain from the sale. Further, the Service ruled that the gain would be treated as passive basket income under 904(d). (b) The case for foreign source income treatment of gain would be stronger than the one in LTR 9142032 if the partner who sells the interest is a foreign entity that has made a checkthe-box election to be treated as disregarded for U.S. federal income tax purposes. In this case both the partner and the partnership would have foreign offices to which the sale could be attributed. The same rule should apply in respect of a domestic partners distributive share of the partnerships income from the sale of personal property, assuming the partnership conducts its business outside of the U.S. A partnership is generally treated as an aggregate in determining the source of its income ( 865(i)(5)), and income from the sale by a partnership of personal property should be treated as attributable to the partnerships foreign office. Mirror rules apply in respect of the sourcing of losses. See generally Treas. Reg. 1.865-1. Thus, under the rationale of LTR 9142032, the loss of a domestic partner who sells a foreign partnership interest would be foreign source provided that the foreign tax requirement is satisfied. In this regard, the regulations state that the loss is allocable to foreign source income if a gain on the sale of the property would have been taxable by the foreign country and the highest marginal rate of tax imposed on such gains in the foreign country is at least 10 percent. Treas. Reg. 1.8651(a)(2). Note that this rule does not require the foreign tax to have been hypothetically paid.
(c)
(d)
5.
There also could be differing source and 904(d) basket consequences in respect of payments to a retiring partner depending on how the payments are characterized. Payments to a
retiring partner either are treated as made in exchange for partnership property ( 736(b)) or are treated as payments of the partners distributive share of partnership income or as guaranteed payments ( 736(a)). (a) Payments treated as made in exchange for partnership property would be sourced in accordance with the rules discussed above, i.e., aggregate treatment in respect of partners who own at least a 25 percent capital or profits interest; foreign source, passive basket income in other cases. Payments treated as a distributive share of partnership income should receive look-through treatment for 904 purposes in respect of partners who own a 10 percent or greater interest in the partnership. Treas. Reg. 1.9045(h). There are no explicit rules for determining the source and character of a guaranteed payment for capital. Under general sourcing principles, which provide that income is sourced in accordance with the situs of the income generating assets and activities, one would expect that guaranteed payments received from a partnership using the capital in a foreign business would be foreign source income. See Rev. Rul. 73-252, 1973-1 C.B. 337. A guaranteed payment for services should be sourced according to where the services are performed. 861(a)(3) and 862(a)(3). A guaranteed payment presumably would fall into the general basked for 904 purposes, as it is not described in any specific 904 category. 904(d).
(b)
IV.
Partnership with U.S. and Foreign Partners Conducting Business Inside the U.S. A. In General 1. U.S. persons who are partners in a partnership that conducts business in the U.S. will be on more familiar territory. The domestic tax issues are more well-settled, and commercial issues will be more straightforward since the partnership entity likely will be organized under domestic law. Rather, it is the foreign partners who will have the principal onus of harmonizing the laws of two jurisdictions. While issues unique to foreign partners might not affect the U.S. partners from a technical tax perspective, U.S. partners will need to
2.
be sensitive to these issues in structuring the transaction. It often is advisable for U.S. partners to retain counsel in the countries of its foreign partners to be well-advised on possible issues that the foreign partners might raise. B. Section 1446 Withholding 1. Section 1446 cannot be ignored if a partnership will, or even might, have taxable income that is effectively connected with the conduct of a U.S. trade or business. Without proper planning, 1446 could result in the partnershipor even worse, the U.S. partnershaving to pay the foreign partners U.S. tax liability. Section 1446 applies without regard to whether the partnership is organized under domestic or foreign law. Section 1446 imposes a withholding tax on the amount of U.S. effectively connected taxable income (ECTI) allocable to a foreign partner. Income exempt from U.S. tax under a treaty is outside the scope of 1446 provided the partnership receives the proper documentation from a foreign partner. Treas. Reg. 1.1446-2(b)(2)(iii). A U.S. office of a partnership that otherwise would qualify as a permanent establishment under an income tax treaty is treated as a permanent establishment of its partners. See Donroy v. United States, 301 F. 2d 200 (9th Cir. 162), and Unger v. Commissioner, 936 F. 2d 1316 (DC Cir. 1991). See also Rev. Rul. 2004-3 (holding that a German partner in a service partnership with a U.S. office is subject to U.S. net income taxation on his allocable share of the partnerships income attributable to the partnerships U.S. office even though the German partner never performed services while physically located in the U.S.) If a partnership does not obtain certification as to the domestic or foreign status of a partner (through forms W-8BEN, W-8IMY, W8 EXP, and/or W-9), or if a partnership receives such a form but has knowledge or reason to know that the information contained therein is incorrect or unreliable, the partnership must presume that the partner is a foreign person. Treas. Reg. 1.1446-1(c)(3). (a) The presumption does not apply to the extent the partnership relies on other means to ascertain the nonforeign status of a partner.
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(b)
The regulation state that a partnership may substitute its own form for the official version of Form W-8 (e.g., Form W-8BEN) to ascertain the identity of its partners, provided such form is consistent with Treas. Reg. 1.14411(e)(4)(vi). Treas. Reg. 1.1446-1(c)(5). This is the only officially sanctioned other means by which a partnership can determine the non-foreign status of a partner. Partnerships would be well-advised to obtain only certification from its partners that has official sanction, or otherwise treat those partners who do not provide such certification as foreign. Special rules apply in respect of tiered partnerships so that a lower-tier partnership that receives the proper documentation need not withhold on payments ultimately allocable to an upper tier domestic person to the extent the lower tier partnership can reliably associate its ECTI to such upper tier U.S. person. Treas. Reg. 1.1446-5.
(c)
(d)
7.
A foreign partners allocable share of ECTI is equal to that foreign partners distributive share of the partnerships gross income and gain for a partnership taxable year that is allocable to that partner in accordance with the partnership agreement reduced by that partners distributive share of partnership ECI deductions (provided that all allocations are respected under 704 and the regulations thereunder). Treas. Reg. 1.1446-2(b)(1). Certain items are not taken into account, such as a partners NOL deductions, a partners losses from outside the partnership during the year, and a partners share of the partnerships foreign taxes. See generally, Treas. Reg. 1.1446-2(b)(3). See also Treas. Reg. 1.1446-6, discussed below. (a) (b) Thus, in many cases a partnership must withhold more tax than a foreign partner is ultimately required to pay. The foreign partner may generally claim a credit under 33 for its share of any 1446 tax paid by the partnership against the amount of income tax as computed in such partners return. Treas. Reg. 1.1446-3(d)(2). A foreign partner generally may credit an installment of 1446 tax paid by the partnership on the partner's behalf against the partner's estimated tax that the partner must pay
(c)
during the partner's own taxable year. Treas. Reg. 1.14463(d)(1)(i). 8. The final regulations permit a partnership to take into account the type of income or gain allocable to the foreign partner during the taxable year when computing its 1446 withholding obligation. As a result, a partnership can generally pay 1446 tax using the highest capital gains rate to the extent long-term capital gain is allocable to a non-corporate foreign partner. Treas. Reg. 1.14463(b)(2)(ii). A partnership is prohibited from using a preferential rate in computing its 1446 tax on income or gain allocable to a foreign partner where the preferential rate depends upon the corporate or non-corporate status of the partner and either such status has not been established by documentation or the regulations otherwise instruct the partnership to pay 1446 tax at the higher of the applicable rates in section 1446(b). Id. The partnership pays the 1446 tax by making quarterly installment payments, with any remaining tax for the year paid with the filing of the partnerships return for the year. Treas. Reg. 1.1446-3(d)(1)(ii). Pursuant to the statute, amounts withheld by a partnership under 1446 with respect to a partner are treated as distributed to that partner. 1446(d)(2); see also Treas. Reg. 1.1446-3(d)(2)(v). The regulations add that 1446 withholding must be made without regard to whether the partnership makes any distributions during the partnerships taxable year. Treas. Reg. 1.1446-3(b)(1). Thus, the proposed regulations essentially mandate distributions to foreign partners. (a) This can have an important impact on the partners business deal. For example, suppose that a partnership agreement has a provision that calls for distributions to enable the partners to pay their tax liabilities arising from the partnerships income. A partnership that is profitable after a period of start-up losses might not make tax liability distributions until the partnership recoups these losses. However, the proposed regulations, which do not take into account net operating loss carryovers, essentially force premature tax liability distributions to the foreign partners. Thus, the partnership may be faced with the choice of either making disproportionate distributions to the foreign partners (through 1446 withholding) or making
9.
10.
distributions to all partners at a time before the parties otherwise might have considered it desirable. (b) The partnership agreement perhaps could require the foreign partners to make capital contributions to the extent of any disproportionate distributions to them as a result of 1446 withholding, but there would be a lag between the time the foreign partners make their capital contributions and the time they receive a refund under 33.
11.
A deemed distribution under 1446(d) is treated as an advance or drawing within the meaning of Treas. Reg. 1.731-1(a)(1)(ii) against the partner's distributive share of income from the partnership. As a result, the tax ramifications of a partnership's payment of 1446 tax on a foreign partner's allocable share of ECTI will be considered by the partner at the end of the partnership's taxable year, or the last day of the partnership's taxable year during which such person was a partner in the partnership. The advance or drawing treatment applies only to installment payments of 1446 tax made during the partnership's taxable year with respect to ECTI earned in the same taxable year. Any 1446 tax paid after the close of the partnership's taxable year that are on account of partnership ECTI allocated to partners for the prior taxable year are treated under section 1446(d) and the regulations as a distribution from the partnership on the earlier of the last day of the partnership's prior taxable year for which the tax is paid, or the last day in such prior taxable year on which such foreign partner held an interest in the partnership. The rules the final regulations apply only for purposes of determining the tax ramifications of the deemed distribution to a foreign partner under 705, 731, and 733, and do not affect the date that the partnership (or partner) is otherwise considered (or deemed) to have paid tax for purposes of 6654 and 6655. Treas. Reg. 1.1446-3(d)(iv). A partnership that is required to pay a tax under 1446 is made liable for the tax under 1461. Treas. Reg. 1.1446-3(e)(1), and 1.1461-3. (a) A partnership can be relieved of this liability if it demonstrates to the satisfaction of the Service under the rules of Treas. Reg. 1.1446-3(e)(2) that the foreign partner has paid the full amount of tax required to be paid by such partner. Treas. Reg. 1.1446-3(e)(1).
12.
(b) (c)
A partnership still is liable for interest and penalties, however. Treas. Reg. 1.1446-3(e)(3). See also 1463. A partnership seemingly should be liable only for the amount of tax owed by the foreign partner and not the amount required to be withheld under 1446. Cf. TAM 8709003 (November 4, 1986). The regulations are silent as to whether partners are jointly and severally liable with the partnership for tax not withheld. Rev. Proc. 89-31 states that general partners are jointly and severally liable as withholding agents for the partnership. Rev. Proc. 89-31, 4.01. Furthermore, the instructions to Form 8804 state that both general partners and limited liability company members are jointly and severally liable as withholding agents for the partnership. To mitigate their exposure for their foreign partners tax liability, U.S. partners should negotiate for broad authority over whether and the extent to which a partnership pays tax under 1446. Whether and the extent to which the U.S. partners exercise this authority is both a tax and a business issue, but the bottom line is that it is very important for U.S. partners to have this authority.
(d)
(e)
13.
Under Treas. Reg. 1.1446-6, certain foreign partners may certify deductions and losses to a partnership to reduce the 1446 tax required to be paid by the partnership with respect to ECTI allocable to such partners. A foreign partner's certificate may only be considered for the partnership taxable year for which it is submitted. Therefore, a foreign partner that wants to certify its deductions and losses in consecutive years must submit a new certificate each partnership taxable year.
C.
Foreign Partners Filing U.S. Federal Income Tax Return 1. If foreign partners do not timely file their U.S. federal income tax returns, then their allocable share of the partnerships effectively connected gross income will not be reduced by deductions, and their U.S. tax liabilities will not be reduced by credits. See Treas. Reg. 1.882-4(a)(2) (foreign corporations); and Treas. Reg. 1.874-1(a) (nonresident alien individuals). This could have a material impact on a partnerships (or its partners) ultimate liability for 1446 taxes not withheld or under withheld. If foreign partners do not file U.S. federal income tax
2.
returns, then the partnerships (or a partners) ability to argue that its personal liability for taxes not withheld under 1446 should be reduced to reflect the actual tax owed by the foreign partners would be diminished. 3. Accordingly, U.S. partners should negotiate for the partnership agreement to include a provision requiring foreign partners to timely file U.S. federal income tax returns, even if such returns show zero effectively connected income.
D.
Sale or Exchange of Partnership Interest 1. The Service appears to take the position that the black letter rule of 741 that the sale or exchange of a partnership interest is treated as the sale or exchange of a capital asset might not apply in respect of foreign partner in a partnership that conducts a U.S. trade or business. Rev. Rul. 91-32, 1991-1 C.B. 107, states that a foreign partners gain or loss from the disposition of a partnership interest is treated as gain or loss that is effectively connected with the conduct of a U.S. trade or business (ECI) to the extent that the partnerships assets are U.S. source property of a partnership engaged in a trade or business through a fixed place in the U.S. If a treaty applies, then a partner is treated as having a permanent establishment in the U.S. if the partnership has a permanent establishment in the U.S. The soundness of the conclusion in Rev. Rul. 91-32 has been questioned, especially given the definitiveness of 741. Nevertheless, Rev. Rul. 91-32 should be given due consideration in planning for any partnership that is or might be treated as engaged in a U.S. trade or business.
2.
3.
V.
Partnerships with a Foreign Subsidiary as a Partner A. Overview 1. A U.S. person typically will hold an interest in a foreign partnership through a foreign subsidiary if it does not want the foreign partnerships tax items to flow through to the U.S. return. A partnership with this structure almost invariably will be a foreign entity operating a foreign business. Thus, the issues discussed in section III above regarding harmonizing U.S. and foreign law are not nearly as acute.
2.
Nevertheless, the foreign subsidiarys distributive share of the partnerships tax items will be important in determining the foreign subsidiarys earnings and profits and foreign taxes for U.S. federal income tax purposes. This will have an effect on whether and the extent to which the U.S. parent may claim deemed paid foreign tax credits. Thus, issues in respect of partnership allocations still will be important. Furthermore, if the foreign subsidiary is a controlled foreign corporation (CFC), then a key tax consideration is whether the CFCs distributive share of the partnerships income would be treated as Subpart F income.
3.
B.
Aggregate-Entity-Conduit Treatment 1. Subchapter K as applied to CFCs incorporates a mixture of aggregate, entity, and conduit concepts. (a) Under the aggregate approach, partners are treated as if they directly own their proportionate share of the partnerships assets and directly receive their proportionate share of the partnerships income. Under the entity approach, the partnership is treated as an entity separate from its partners. Under the conduit approach, the partnership is treated as separate from its owners, but certain items of the partnership are characterized by reference to the partners.
(b) (c)
2. 3.
Subpart F does not uniformly adopt either the aggregate, entity, or conduit approaches. Examples of entity treatment include (a) A domestic partnership is treated as a entity for purposes of determining U.S. shareholder and CFC status. 957(c).
(b)
In the case of a CFC who owns less than a 25 percent capital or profits interest, the sale of a partnership interest by the CFC is treated as the sale of a capital asset without a look through to the partnerships underlying assets. 954(c)(1)(B)(ii), (c)(4).
4.
Examples of aggregate treatment include (a) (b) A CFC-partner for purposes of 956 is treated as holding its pro rata share of the property held by its partnership. In the case of a CFC that owns at least a 25 percent capital or profits interest, the sale of a partnership interest by the CFC is treated as a sale of a proportionate share of the partnerships assets. 954(c)(4).
5.
An example of conduit treatment is that the determination of whether a CFC-partners share of partnership income is subpart F income in the CFC-partners hands, is generally determined by reference to the attributes of the partner.
C.
Background of Anti-Brown Group Regulations 1. The Service cleared up much confusion in the Subpart F area when it issued regulations (the anti-Brown Group regulations) in June 2002. However, important lingering questions and issues remain. A typical fact pattern involves a U.S. shareholder which owns 100% of the shares of a CFC organized in country A which, in turn, is a partner in a partnership organized in country B. The partnership purchases products manufactured by the U.S. parent and sells the products to unrelated customers in country B. If the partnerships income were tested for Subpart F status at the partnership level, the product would be treated as sold within the partnerships country of organization, and no Subpart F income would result. If the partnerships income were tested at the partner/CFC level, the product would be treated as sold outside of the partners/CFCs country of organization, and Subpart F income would result. This issue was particularly acute before 1987, where the old 954(d)(3) provided only that a partnership that controlled a CFC was related to the CFC. The Tax Reform Act of 1986 amended the 954(d)(3) definition of a related person to treat a partnership controlled by, or under common control with, a CFC as related to
2.
3.
the CFC. (Section 954(d)(3) still does not treat a partnership as related to its U.S. shareholder.) 4. Congress considered the pre-1987 rule regarding related persons as without logical support because a CFC could avoid [Subpart F] treatment merely by operating in a third country through a partnership rather than a corporation. 1986 Blue Book at 989. Thus, Congress implicitly acknowledged that in testing for Subpart F status, a partnerships income should be tested at the partnership level and not at the CFC/partner level. The Service, however, took a different view, stating in Rev. Rul. 89-72, 1989-1 C.B. 257, that in testing for Subpart F status, a partnerships income should be characterized at the CFC/partner level. The courts bounced back and forth on this issue in the series of Brown Group cases, with the Tax Court initially agreeing with Congress implicit view and then vacating its initial decision, and then the Eighth Circuit adopting (with additional reasoning of its own) the reasoning and holding of the first Tax Court decision. The anti-Brown Group Regulations adopt the Services approach in Rev. Rul. 89-72. Treas. Reg. 1.702-1(a)(8)(ii) states that,
[e]ach partner must take into account separately the partners distributive share of any partnership item which, if separately taken into account by any partner, would result in an income tax liability for that partner, or for any other person, different from that which would result if that partner did not take the item into account separately. (emphasis provided).
5.
6.
7.
Further, Treas. Reg. 1.952-1(g) states that generally a CFCs distributive share of an item of a partnerships income is Subpart F income if the item would have been Subpart F income if received by the CFC directly. The anti-Brown Group regulations added the phrase or for any other person to Treas. Reg. 1.702-1(a)(8)(ii). The addition was necessary since the tax liability of the U.S. shareholder of a CFC partner, and not the CFC partner itself, is affected by the CFC partners separate accounting of the partnerships income. It could be argued that this modification, which is at the heart of the anti-Brown Group regulations, is without statutory support. Section 702(a) states that in determining his income tax, each
8.
9.
partner shall take into account separately his distributive share of the partnerships other items of income, gain, loss, deduction, or credit, to the extent provided by regulations . . . (emphasis provided). The statute does not address the tax treatment of shareholder of partners. Certainly, the drafters of 702(a), which was enacted in 1954, before Subpart F was enacted in 1962, were not thinking about this issue. But the statutory authority is what it is. Judge Ruwe in his concurring opinion in the Brown Group decision reviewed by the Tax Court, expressed this sentiment, the fact that we are dealing with a situation that Congress may have intended to tax under Subpart F is not a justification for disregarding the plain language of the partnership provisions 104 T.C. at 121, fn. 2 10. Further, the general mandate of Treas. Reg. 1.952-1(g), that a CFCs distributive share of an item of a partnerships income is Subpart F income if the item would have been Subpart F income if received by the CFC directly seemingly runs counter to 702(b), which states in relevant part that the character of any item of income included in a partners distributive share under, inter alia, 702(a)(7) is determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership. The Service justified this change to the regulation essentially by reference to its view of the policies of Subchapter K and Subpart F. It also cited legislative history of Subchapter K stating that a partnership may be treated as an aggregate or an entity depending on which characterization is most appropriate. T.D. 9008, 2002-2 C.B. 335, 336 The regulations, however, do not really apply an aggregate approach. Rather, the regulations determine whether a partners distributive share of partnership income is Subpart F income generally by reference to attributes of the partner.
11.
D.
Foreign Personal Holding Company Income 1. The sale of a partnership interest gives rise to foreign personal holding company income since the partnership is treated as an entity for this purpose (i.e., no look-through to the partnerships assets). 954(c)(1)(B)(ii). The gain would be passive basket income. Treas. Reg. 1.904-5(h)(3). See also CCA 200224007 (Service applies step transaction doctrine to treat disposition of partnership assets as a disposition of a partnership interest giving rise to foreign personal holding company income).
2.
The anti-Brown Group regulations address the characterization of a CFC-partners distributive share of the partnerships foreign personal holding company income. (a) Treas. Reg. 1.952-1(g)(1) states that a CFCs distributive share of any item of income of a partnership is Subpart F income to the extent the item of income would have been income in such category if received by the CFC directly. Treas. Reg. 1.952-1(g)(2) sets forth an example that illustrates this principle. In the example, a partnership receives interest income. If the interest income had been received directly by the CFC-partner, it would have been Subpart F income. Thus, the CFCs distributive share of the interest income is subpart F income.
(b)
3.
Treas. Reg. 1.954-1(g)(1) states that unless otherwise provided, to determine the extent to which a CFCs distributive share of any item of income of a partnership would have been subpart F income if received by it directly under Treas. Reg. 1.952-1(g), if a provision of subpart F requires a determination of whether an entity is a related person within the meaning of 954(d)(3), or whether an activity occurred within or outside the country under the laws of which the CFC is created or organized, this determination is made by reference to the CFC and not by reference to the partnership. Treas. Reg. 1.954-2(a)(5)(ii)(A) states that in determining whether a CFCs distributive share of an item of income of a partnership is foreign personal holding company income, the exceptions based on a CFC being engaged in the active conduct of a trade or business apply only if the exception would have applied to exclude the income from FPHCI if the CFC had earned the income directly, determined by taking into account only the activities of, and property owned by, the partnership and not the separate activities or property owned by the CFC or any other person.
4.
CFC
(Country A)
Other Partner
80
20
royalty
P
(Country B) develops IP
License
Unrelated Licensee
(a)
These rules are not clear in respect of de facto partnerships and certain foreign partnership that cannot, as a matter of local law, own property or conduct activities. It is a longstanding principal of federal tax law that two or more parties can be treated as partners in a partnership even if the parties do not conduct business through a legal entity. Instead, the material factor in determining whether a partnership exists for federal tax purposes is the relationship between the parties, and particularly whether the parties join together to conduct a business as partners. See Commissioner v. Culbertson, 337 U.S. 744, 742 (1949) (a partnership exists for federal tax purposes if the parties in good faith and acting with a business purpose intended to join together in the present conduct of an enterprise.). See also Treas. Reg. 301.7701-1(a)(2) (a joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade [or] business . . . and divide the profits therefrom.) Consider a two parties who jointly develop intellectual property and divide the profits from the venture. For federal tax purposes, the parties will be treated as partners, but there is no legal entity which owns property or conducts activities. One would expect that the de facto partnership would be treated for purposes of the anti-Brown Group regulations as owning the real estate and conducting the management activities for purposes of determining whether its partners share of its rental income is FPHCI. The preamble appears to contemplate that this should be the
(b)
(c)
answer, stating that the policies of Subpart F are best served by applying the relevant active trade or business tests at the level of the entity that actually earns the income (i.e., the partnership). T.D. 9008 Clarification in this regard would be helpful. (d) This issue ripples through other provisions of the Code, such as the foreign tax credit and passive foreign investment company (PFIC) provisions, both of which reference the foreign personal holding company rules to determine whether an item of income is passive income. See 1297(b)(1) (PFIC rule), and 904(d)(2)(A)(i) (foreign tax credit rule). In addition, certain foreign business associations that typically are treated as partnerships for federal income tax purposes cannot, as a matter of foreign commercial law, own property or conduct activities in their own names. For example, a U.K. general partnership, a German stille gesellschaft (silent partnership), and a Japanese tokumei kumiai (TK) cannot legally own property. Further, a stille gesellschaft and a tokumei kumiai cannot conduct business in their own names. One would expect that these entities would be treated as owning property and conducting activities for purposes of the anti-Brown Group regulations.
(e)
5.
Transactions between a CFC-Partner and its Partnership (a) It would appear that a CFC-partners distributive share of partnership income arising from a transaction between the CFC-partner and the partnership is not foreign base company sales income since the regulations suggest that the CFC-partner would be treated as dealing with itself. (i) Treas. Reg. 1.952-1(g)(1) states in this regard that a CFCs distributive share of any item of income of a partnership is Subpart F income to the extent the item of income would have been income in such category if received by the CFC directly. The Service perhaps could argue that the CFC should be treated as receiving the income (see 707(a)), but that the income is not received from a related person (a CFC is not related to itself under 954(d)(3)).
(ii)
(b)
An entity approach would seem to apply to a CFC-partners income from a transaction with its partnership. 707(a). In this regard, a person is related with respect to a CFC if the person is a partnership which controls or is controlled by the CFC, or is a partnership which is controlled by the same person or persons which control the CFC. 954(d)(3).
6.
A CFCs distributive share of partnership income is not excluded from foreign personal holding company income under the 954(h) active financing exception unless the CFC is an eligible CFC within the meaning of 954(h)(2) (taking into account the income of the CFC and any partnerships or other QBUs, within the meaning of 989(a), of the CFC, including the CFCs distributive share of partnership income) and the partnership, of which the CFC is a partner, generates qualified banking or financing income within the meaning of 954(h)(3) (taking into account only the activities of the partnership. Treas. Reg. 1.954-2(a)(5)(ii)(B). A CFCs distributive share of partnership income is not excluded from foreign personal holding company income under the exception in 954(i) (qualifying insurance corporation) unless the CFC-partner is a qualifying insurance corporation, as defined in 953(e)(3) (determined by examining premiums written by the CFC and any partnerships or other QBUs, within the meaning of 989(a), of the CFC partner), and the partnership, of which the CFC is a partner, generates qualified insurance income within the meaning of 954(i)(2) (taking into account only the income of the partnership.
7.
E.
Foreign Base Company Sales Income 1. Treas. Reg. 1.954-1(g)(1) states that in determining whether a CFCs distributive share of partnership gross income would have been subpart F income if received by it directly under Treas. Reg. 1.952-1(g), if a provision of subpart F requires a determination as to whether an entity is a related person within the meaning of 954(d)(3), or whether an activity takes place in or outside the country under the laws of which the CFC is created or organized (for purposes of determining whether the income qualifies for the same country exception) the determination is made with respect to the CFC-partner and not the partnership. For purposes of determining whether a CFCs distributive share of any item of gross income of a partnership is foreign base company
2.
sales income when the item is derived from the sale by the partnership of personal property purchased by the partnership from (or sold by the partnership on behalf of) the CFC; or the sale by the partnership of personal property to (or the purchase of personal property by the partnership on behalf of) the CFC (the CFCpartnership transaction), the CFC-partnership transaction will be treated as a transaction with an entity that is a related person within the meaning of 954(d)(3), under Treas. Reg. 1.954-1(g)(1) if (a) the CFC purchased the personal property from (or sold it to the partnership on behalf of), or sells the personal property to (or purchases it from the partnership on behalf of), a related person with respect to the CFC; or the branch rules of 954(d)(2) applies to treat as foreign base company sales income the income of the CFC from selling to the partnership (or a third party) personal property that the CFC has manufactured, in the case where the partnership purchases personal property from (or sells personal property on behalf of) the CFC. Note the clear respect of a partnership as an entity under this rule.
(b)
3.
An example that matches the Brown Group facts describes a CFC organized in country A that is a partner in partnership P. P is also organized in country A. P purchases product from unrelated manufacturers in country B and sells such product to the U.S. parent, earning a commission. To determine whether the CFCs distributive share of the partnerships income is subpart F income, the CFC is treated as if it purchased the product. Because the product is both produced and manufactured in country B (outside of CFCs country of organization) and the product is sold outside of CFCs country of organization, the CFCs distributive share of Ps sales income is foreign base company sales income.
USP
product CFC
(Country A)
Commission fee
P
(Country B)
Unrelated Mfgr. (Country B)
product
Ps commission for purchase of product on behalf of USP. Product is mfg. in country B. CFC has FBCSI.
.
P C o u n t r y B ______________________________________________________________________________ - 79 David L. Forst Fenwick & West LLP
4.
A second example describes a country B partnership with two partners: CFC-1, organized in country A, and CFC-2, organized in country B. CFC-1 and CFC-2 are owned by the same U.S. parent company. The partnership purchases product manufactured by CFC-2 in country B and sells the product to unrelated parties located in country B. To determine whether CFC-1s distributive share of Ps sales income is foreign base company sales income, CFC-1 is treated as if it purchased the product from CFC-2 and sold it to third parties in country B. CFC-1 and CFC-2 are related persons, and the product is both manufactured and sold outside of CFC-1s country of organization. Thus, CFC-1 has foreign base company sales income. CFC-2 does not have foreign base company sales income because the product is both manufactured and produced in country B.
USP
100
100
CFC 1
(Country A )
CFC 2
(Country B )
MFGS PRODUCT
80 20
PR
CT DU O
P
COUNTRY B PRODUCT UNRELATED IN COUNTRY B
CFC1s Share of Ps Income is FBCSI
5.
A third example describes a CFC organized in country A that is a partner in a partnership organized in country B. The CFC purchases goods from a related person organized in country C. The CFC sells the goods to the partnership, which sells them to an unrelated country D corporation. The goods are manufactured in country C by an unrelated person. The CFCs distributive share of the partnerships sales income is treated as income from the sale of goods purchased from a related person. This is because CFC purchased the goods from a related person. The goods were both manufactured and produced outside of country A, and thus, the CFCs distributive share of the partnerships sales income is foreign base company sales income. In addition, the CFCs income from the sale of goods to P is also foreign base company sales income.
Goods (Mfg in Country C)
CFC
(Country A)
J Corp.
(Related to CFC)
80
goods
P (Country B) (Country B)
CFCs income from sale of goods to P is Sub F. (Note entity treatment) CFCs share of Ps income is Sub F
goods Unrelated Country D
6.
The fourth example is the same as the third except that the partnership purchases goods from the unrelated person in country D and sells the goods to the CFC. CFC sells the goods to a related party in country C, and the country C related party sells the goods to an unrelated party in country C. Because the goods were both manufactured and sold for use outside of country A, CFCs distributive share of the partnerships income is foreign base company sales income. CFCs income from the sale of goods to the related country C corporation is also subpart F income.
CFC
(Country A) goods 80
goods
J Corp.
(Related to CFC, Country C)
goods
Unrelated In Country C
goods P P
Unrelated Country D
(Country B) (Country B)
CFCs share of Ps income is Sub F (sale of goods to a related person for ultimate use outside of Country A) CFCs income from sale of goods to J Corp. is Sub F
7.
Treas. Reg. 1.954-3(a)(6) states that in applying the manufacturing exception to foreign base company sales income, the property sold by a partnership will be considered to be manufactured by a CFC-partner only if the manufacturing exception would have applied to exclude the income from foreign base company sales income if the CFC had earned the income directly, determined by taking into account only the activities of, and property owned by, the partnership and not the separate activities or property of the CFC or any other person. (a) Note that this rule is an exception to the general approach of the anti-Brown Group regulations, since the characteristics of the partnership, and not the partners, are the material consideration. This rule would seem to preclude the activities of a contract manufacturer from being attributed to the partnership. The same issues with de facto partnerships and certain foreign entities treated as partnerships that cannot own property arise here. See discussion at V.B.4 above.
(b) (c)
(d)
The example illustrating this rule states that CFC, organized under the laws of country A, is a partner in Partnership. The Partnership is organized under the laws of country B. The partnership performs activities in country B that rise to the level of manufacturing. The Partnership, through sales offices in country B sells the product to an unrelated party for use in country B. The CFCs distributive share of the Partnerships sales income is not foreign base company sales income because the manufacturing exception would have applied to exclude the income from foreign base company sales income if CFC had earned the income directly.
CFC
(Country A)
80
Product
(Country B) (Country B)
P P
mfgs
D (Related Country B)
8.
Treas. Reg. 1.954-4(b)(2)(iii) states that when a partnership is related to a CFC-partner, the partnership performs services for a person unrelated to the CFC-partner, and the CFC-partner or a related person provides substantial assistance to the partnership, the CFC-partner and the partnership are treated as separate entities and the substantial assistance provided to the partnership by the CFC partner, or a related person, will cause the CFC-partners distributive share of the services income to be treated as foreign base company sales income. Branch Rule (a) The anti-Brown Group regulations do not resolve whether or the extent to which the branch rule applies in respect of partnerships that conduct manufacturing and/or sales activities. The branch rule states in general that a branch
9.
or similar establishment of a CFC which is located outside of the CFCs country of organization can be treated as a wholly owned subsidiary of the CFC for purposes of determining foreign base company sales income. 954(d)(2) The branch rule is intended to prevent CFCs from using branches to split the manufacturing and selling of products, with the profits derived from selling subject to a lower rate of foreign tax than the profits derived from manufacturing. (b) The branch rule applies when the use of a branch has substantially the same tax effect as if the branch were a wholly owned subsidiary of the CFC. The use of a branch generally has substantially the same tax effect if selling (whether conducted by a branch or the CFC in its country of organization) is taxed at an effective rate that is less than 90 percent of, and at least 5 percentage points less than, the effective rate imposed in respect of manufacturing (whether conducted by a branch or the CFC in its country of organization). See Treas. Reg. 1.954-3(b)(1). The anti-Brown Group regulations silence on the branch rule issue likely is because Congress did not give the Service the authority to define a branch or similar establishment, and it is by no means facially evident that a partnership should be treated as a branch or similar establishment. See Ashland Oil, Inc. v. Commissioner, 95 T.C. 348, 357-8 (1990). One example in the anti-Brown Group regulations (Treas. Reg. 1.954-3(a)(6)(ii)) describes a CFC organized in Country A that holds an 80% interest in a partnership organized in Country B. The example states that the Partnership both manufactures and sells products in Country B. Even if the partnership were treated as a branch or similar establishment within the meaning of the branch rule, the branch rule would not apply as both the manufacturing and selling are taxed in the same country at the same effective tax rate. The example does not, and need not, mention the branch rule. In the proposed version of the anti-Brown Group regulations, this example contained a parenthetical stating, [t]he branch rule . . . does not apply to these facts. It is not clear whether the Service believed that the branch rule could not apply to partnerships or whether the Service merely was clarifying
(c)
(d)
that the branch rule would not apply even if the partnership were treated as a branch or similar establishment of the CFC. The anti-Brown Group regulations do not have an example with manufacturing and selling in different countries.
LISP
CFC
CFC
MFG
SALES
(e)
The Tax Court twice has interpreted the term branch or similar establishment. On neither occasion was a partnership at issue, but the cases nonetheless provide useful guidance. In Ashland Oil, Inc. v. Commissioner, supra the Tax Court held that an unrelated contract manufacturer was not a branch or similar establishment. The Tax Court stated that Congress intended the term branch to have its customary business meaning, and for the term similar establishment to serve a fine tuning purpose rather than an expansionary one. This statement would suggest that a partnership should not be treated as a branch or similar establishment, since from a business perspective partnerships and branches are fundamentally different. (Blacks Law Dictionary defines a partnership as, a voluntary association of two or more persons who jointly own and carry on a business for profit. This definition is fundamentally different from the Blacks Law Dictionary definition of branch.) Further, the Tax Court rejected the Services argument that the branch rule should apply to any arrangement with the requisite tax rate disparity. The court also noted that under the facts at issue
the CFC had no claim over the unrelated contract manufacturers income. (f) In Vetco, Inc. v. Commissioner, 95 T.C. 579 (1990), the Tax Court held that a wholly owned subsidiary of a CFC could not be treated as a branch or similar establishment. Even if a partnership itself does not fit within the definition of branch or similar establishment, the assets and activities of a partnership, perhaps, could be treated as activities of the partner, and hence as a branch or similar establishment, under the aggregate theory of partnerships. However, there is ample precedent in the Subpart F area that partnerships should be treated as entities. Section 954(f)(2) treats a partnership as an entity in respect of foreign base company shipping income. Section 957(c) treats a partnership as an entity for purposes of determining whether a foreign corporation is a CFC. Section 954(c)(1)(B)(ii) treats a partnership as an entity for purposes of determining whether the sale of a partnership interest is foreign personal holding company income. Additionally, and perhaps most importantly, 954(d)(3), the provision that was the subject of the Brown Group litigation, was amended in 1986 to treat a partnership controlled by a CFC (or by the same person(s) as the CFC) as an entity for purposes of determining status as a related person. A partnership that controlled a CFC was treated as entity before the 1986 amendments. Also, the anti-Brown Group regulations themselves, would not support application of the branch rule, as they do not take an aggregate approach. Authority outside of Subpart F could lend support to an argument that a partnership should be treated as a branch or similar establishment. Two courts of appeals have held that the U.S. office of a limited partnership should be treated as the office of its partners for purposes determining whether its foreign partners have a permanent establishment in the U.S. Donroy and Unger, supra. Further, if a partnership were availed of for the principal purpose of avoiding the branch rule, the Service could seek to invoke an anti-abuse rule, such as Treas. Reg. 1.7012(e), to treat the partnership as an aggregate or otherwise disregard the partnership.
(g)
(h)
(i)
F.
Foreign Base Company Services Income 1. The general rule of Treas. Reg. 1.952-1(g) is important here, stating that a CFCs distributive share of an item of a partnerships income is Subpart F income if the item would have been Subpart F income if received by the CFC directly. Thus, in determining where services are performed and whether the services are performed for a related person, testing is done at the CFC-partner level. Treas. Reg. 1.954-4(b)(2)(iii) states that a CFCs distributive share of partnership services income will be deemed to be derived from services performed for on behalf of a related person, within the meaning of 954(e)(1)(A), if the partnership is a related person with respect to the CFC under 954(d)(3), and, in connection with the services performed by the partnership, the CFC, or a person that is a related person with respect to the CFC, provided assistance that would have constituted substantial assistance contributing to the performance of such services, under Treas. Reg. 1.954-4(b)(2)(ii), if furnished to the CFC by a related person. Thus, when the partnership is performing services for a person unrelated to the CFC-partner, but the CFC-partner, or a related person, provides substantial assistance to the partnership, the CFCpartner and the partnership are regarded as separate entities, and the substantial assistance provided to the partnership by the CFC partner, or a related person, cause the CFC-partners distributive share of the services income to be treated as foreign base company services income. In Notice 2009-7 the IRS identified as a transaction of interest an arrangement using a domestic partnership under which a U.S. taxpayer that owns controlled foreign corporations (CFCs) that hold stock of a lower-tier CFC through a domestic partnership takes the position that subpart F income or 956 investment of the lower-tier CFC does not result in income inclusions under 951(a) for the U.S. taxpayer. As a result, taxpayers who enter into these transactions on or after November 2, 2006, must disclose the transaction as described in Reg. 1.6011-4. The Notice states that in a typical transaction, a U.S. taxpayer (Taxpayer) wholly owns two CFCs, (CFC1 and CFC2). CFC1 and CFC2 are partners in a domestic partnership (US Partnership). US
2.
3.
4.
G.
Notice 2009-7 1.
2.
Partnership owns 100 percent of the stock of another CFC (CFC3). Some or all of the income of CFC3 is subpart F income or CFC has made an investment in U.S. property under 956. As part of the transaction, Taxpayer takes the position that the subpart F income or 956 investment of CFC3 is currently included in the income of US Partnership (which is not subject to U.S. tax) and is not included in the income of Taxpayer. 3. The result of the claimed tax treatment, according to the Notice, is that income that would otherwise be taxable currently to Taxpayer is not taxable to Taxpayer because of the interposition of a domestic partnership in the CFC structure. The Notice states that the IRS and Treasury are concerned that taxpayers are taking the position these types of structures result in no income inclusion to Taxpayer under 951. Therefore the IRS and Treasury are identifying as transactions of interest such structures with respect to which the Taxpayer takes the position that there is no income inclusion to Taxpayer under 951, as well as substantially similar transactions. The IRS and Treasury believe that the position there is no income inclusion to Taxpayer under 951 is contrary to the purpose and intent of the provisions of subpart F. Where all of the partnerships interest are held by related parties and the partnership does not conduct any business activity, the IRS presumably could invoke the various anti-abuse measures under Reg. 1.701-2 to deny the desired tax treatment. The IRS route to challenge the structure is seemingly less clear where a partnership engages in a business activity. The Notice states that before the IRS takes further action, in appropriate situations, it may challenge the taxpayer's position under subpart F, subchapter K, or other provisions of the Code or under judicial doctrines such as sham transaction, substance over form, and economic substance.
4.
5.
H.
Section 956 1. The anti-Brown Group regulations treat partnerships as aggregates for purposes of determining the amount of a CFC partners investment in U.S. property. (a) Thus, a CFC partner is treated as directly holding a share of the U.S. property held by its partnership equal to the partners interest in the partnership. Treas. Reg. 1.9562(a)(3); see also Rev. Rul. 90-112, 1990-2 C.B. 186.
(b)
The regulations, however, do not state how a partners interest is determined. The most logical conclusion would be a partners capital interest, as this determines the partners interest in the partnerships assets on liquidation. (In Rev. Rul. 90-112, supra, the CFC partner at issue had the same percentage interest both the capital and profits of the partnership.) The regulations also do not state how the amount of a CFCs investment in U.S. property is determined. Rev. Rul. 90-112 states in this regard that the amount of the investment is the CFCs pro rata share of the partnerships adjusted basis in the U.S. property, limited by the CFCs total basis in the partnership.
(c)
2.
There is no direct authority on whether a CFC would be treated as holding an obligation of a U.S. person if it makes a loan to a partnership which has a U.S. person as a partner. (a) If an entity approach applied, then the residence of the partnership would seem to be the salient factora loan to a domestic partnership would be treated as an investment in U.S. property, and a loan to a foreign partnership would not be treated as an investment in U.S. property (except perhaps if the loan was attributable to the foreign partnerships U.S. trade or business). This approach would be simple, but could be viewed an end-run around 956. (Of course, the Service could seek to treat a partnership as an aggregate by invoking an anti-abuse rule, such as Treas. Reg. 1.701-2(e).)
USP
CFC BV
loan
(b)
Another alternative would be to apply the rules of 752 in determining whether or the extent to which a CFC should be treated holding the obligation of a U.S. person. Under this method, a CFC would be treated as holding an obligation of a U.S. person to the extent of U.S. partners share of the partnerships liability as determined under 752. See generally, Treas. Reg. 1.752-1 through 1.7524. This approach perhaps makes the most sense since a partners share of a partnerships liabilities is treated as cash contributed by the partner to the partnership. 752(a); Treas. Reg. 1.752-1(b). In the preamble to proposed regulations under 954(i), Treasury and the Service requested comments on the application of 956 to loans by CFCs to foreign partnerships. REG-106418-05, 71 Fed. Reg. 2496 (Jan. 17, 2006). The New York State Bar Assn. submitted comments. See NYSBA Tax Section, Report on the Application of 956 to Partnership Transactions (Report No. 1114, June 30, 2006).
(c)
3.
LTR 200832024 (a) Ltr. Rul. 200832024 is a helpful ruling in which the IRS looked to the substance of a partnership structure in concluding that a CFC which was a partner in a partnership conducting a U.S. trade or business did not have a 956 investment. In the ruling a domestic taxpayer (US1) entered into a joint venture with an unrelated foreign party (FC). The joint venture was a foreign entity treated as a partnerhsip for U.S. federal income tax purposes. US1s CFC (F2) was also a member of the joint venture. Prior to F2 becoming a member of the joint venture, F2 was a dormant corporation and did not hold United States property, as defined in 956(c). The joint venture conducts both U.S. businesses and nonU.S. businesses. Assets of the U.S. business constitute United States property under 956(c). The U.S. and nonU.S. businesses are conducted in separate legal entities treated as disregaded for U.S. federal income tax purposes. The respective legal entites will maintain separate books
(b)
(c)
and records and funds will not be loaned or transferred between such entities. (d) The joint venture agreement specifies that F2 will share only in the income, gains, deductions and losses of the Non-US Business and will have liquidation rights only in assets of the Non-US Business. The assets of the non-U.S. business do not include United States property. F2 will not share in any income, gains, deductions or losses from the US Business and will not have any rights to assets of the US Business upon a liquidation of the LLP. It was represented that the allocations have substantial economic effect. Treasury Reg. 1.956-2(a)(3) provides that:
For purposes of section 956, if a controlled foreign corporation is a partner in a partnership that owns property that would be United States property . . . if owned directly by the controlled foreign corporation, the controlled foreign corporation will be treated as holding an interest in the property equal to its interest in the partnership and such interest will be treated as an interest in United States property.
(e)
(f)
The ruling helpfully added a proviso to this rule stating that the substance of the arrangement is relevant. The ruling states that a CFC that has an economic interest in US Property through a partnership would be considered to have an interest in US Property for purposes of section 956 in accordance with the substance of the arrangement. Accordingly, it states that a CFC that does not have, directly or indirectly, any economic interest in US Property through a partnership, including a profits interest, a capital interest, a liquidation right, or any other interest, does not have an interest in US Property for purposes of 956. Accordingly, because F2 will not have an economic interest in the U.S,, including a profit or capital interest, liquidation rights, or any other interest, no economic interest in US Property is being shifted from a CFC to a non-CFC, and LLC1 will not receive any loans, other funds or credit support from LLC2, we conclude that F2's status as a partner in LLP will not cause F2 to be treated as holding an interest in the US Business under Treas. Reg. 1.9562(a)(3).
(g)
I.
Subpart F Deductions and Losses 1. While the focus of the anti-Brown Group regulations is on partnership income, the regulations are silent as to the mechanics of allocating and apportioning a CFC partners distributive share of partnership losses and deductions for Subpart F purposes. Under the general rules of Subpart F, deductions should be allocated and apportioned at the partnership level. The Subpart F regulations apply the principles of 861, 864 and 904(d) in allocating and apportioning deductions against gross foreign base company income. Treas. Reg. 1.954-1(c)(1). These regulations generally treat partnerships as entities. See Treas. Reg. 1.9045(h) and 1.861-8(a)(3)(xiii). Compare Treas. Reg. 1.8619T(e)(2) (specifically providing for aggregate treatment in the case of certain partnership interest expense). An entity approach also would be consistent with the anti-Brown Group regulations themselves. As discussed above, these regulations do not apply the aggregate approach, but rather state that in determining whether a partners distributive share of partnership items is Subpart F income, attributes of a partner generally must be considered. Thus, the anti-Brown Group regulations should not be read as treating items of partnership deduction and loss as partner items in the context of Subpart F. Furthermore, it would be incongruous for a partnership to have a net loss in respect of an activity that gives rise to foreign base company income, but for the partner to have net income due to an aggregate treatment of losses.
2.
3.
4.
J.
Section 987 1. The section 987 issues discussed above also apply when a CFC with one functional currency is a partner in a partnership with a different functional currency. Additional issues are raised if the entity recognizing 987 gain or loss is a CFC. Currency gain could be Subpart F income. The 2006 Proposed Regulations state that the owner of a 987 QBU must use the asset method provided in Treas. Reg. 1.861-9T(g) to characterize and source 987 gain or loss; the modified gross income method set forth in Treas. Reg. 1.861-9T(j) cannot be used. Prop. Treas. Reg. 1.987-6(b)(2). Thus, the taxpayer must use the average tax book value of assets in the year of remittance as the basis for
2.
determining the source and character of 987 gain or loss. The preamble states that sourcing and characterizing 987 gain or loss by reference to post-1986 accumulated earnings would be very complex and may not reflect all items giving rise to such gain or loss. The preamble states that the modified gross income method cannot be used because Treasury and the IRS believe that gross income earned in a single year is not a sufficient proxy for accumulated earnings, whereas a single years assets should generally reflect the activities of a 987 QBUs accumulated earnings. 3. New Treas. Reg. 1.861-9T(g)(2)(ii)(A)(1) states that tax book value is determined by applying the rules of Treas. Reg. 1.8619T(g)(2)(i) and (3) to the beginning of year and end of year functional currency amount of assets, and that such amounts within each grouping must be averaged as provided in Treas. Reg. 1.861-9T(g)(2)(i). A CFCs currency gain or loss also will affect the extent to which a U.S. shareholder can claim 902 credits. Currency gain would increase the CFCs post-1986 earnings and profits pool and therefore dilute its foreign effective tax rate. Currency loss generally would have the opposite effect. However, currency loss, if large enough, could altogether eliminate the CFCs earnings and profits for U.S. federal income tax purposes. If this were to occur, the CFC could not remit a dividend to its U.S. shareholders, and therefore it could not remit foreign tax credits.
4.
K.
Exit Issues 1. The American Jobs Creation Act of 2004 provides for aggregate treatment in determining the character and subpart F nature of gain in the case of partners who own at least 25 percent of the capital or profits interest in the partnership. In other cases, gain is passive basket, foreign personal holding company income. 904(d)(1)(A); 904(d)(2)(A)(i); and 954(c)(1)(B)(ii); 954(c)(4). On liquidation of a partnership, the amount of money or money equivalents distributed that exceed the partners adjusted tax basis in its partnership interest would result in passive basket, foreign personal holding company income. Id. and 731(a)(1).
2.

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INTERNATIONAL JOINT VENTURES

INTERNATIONAL JOINT VENTURES

______________________________________________________________________________ -1David L. Forst Fenwick & West LLP

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