Partnership Issues in International Tax Planning Tax Executives Institute February 16, 2015

Transcription

1 Partnership Issues in International Tax Planning Tax Executives Institute

2 Instructors Craig Gerson WNTS Principal Craig Gerson recently rejoined as a Principal in the Mergers and Acquisitions group of s Washington National Tax Services practice. At, Craig advises clients on the use of partnerships in a wide array of domestic and cross-border transactions. Prior to returning to, Craig served in the Office of Tax Legislative Counsel at the U.S. Department of the Treasury as an Attorney-Advisor specializing in partnership taxation issues. While at the Treasury Department, Craig had primary responsibility for the development and publication of guidance on partnership tax topics, including regulations relating to: distributions under section 751(b); basis adjustments under the Jobs Act of 2004; varying interests under section 706; qualifying income under section 7704(d)(1)(E) for publicly traded partnerships; disguised payments for services under section 707(a); partnership transactions involving partner stock under section 337(d); and allocations of partnership liabilities under section 752. Craig also has prior experience as an Attorney-Advisor in the Passthroughs Division of Chief Counsel. Craig has authored articles that have appeared in numerous publications, including Practising Law Institute (PLI) (Tax Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures and Other Strategic Alliances), Tax Notes, and Journal of Taxation. Craig is a regular speaker on partnership tax issues at a wide variety of tax conferences including the American Bar Association Tax Section, PLI, and Tax Executives Institute. Craig has also instructed the Taxation of Partnerships class for the LL.M. program in taxation at the Georgetown University Law Center. Josh DeMarco Craig received his B.A. in English from Northwestern University, his J.D. from University of California - Davis, and his LL.M. from the Georgetown University Law Center. Craig is admitted to practice law in Washington D.C. and California. International Tax Services Director Josh DeMarco is a director in the International Tax Services (ITS) group in s Houston office. Josh assists clients with a broad range of international tax issues and tax planning, encompassing areas such as international mergers and acquisitions, subpart F, section 956, foreign tax credit utilization, tax-efficient repatriation, foreign currency issues and foreign tax minimization. Josh has extensive experience in global tax integration projects, which encompass numerous areas of tax, including those listed above. Josh is also experienced in US tax compliance for multinational companies. Josh has a Bachelor of Science in Business Administration degree with emphasis in Accounting and Juris Doctor from Ohio Northern University. He is a member of the American Bar Association as well as the bar of the state of Ohio. 2

3 Agenda 1. Notice Section Revised CFTE Allocation Regulations 4. May Company Regulations 5. Rev. Rul Other Hot Topics/Questions 3

4 Notice

5 Discussion Framework Base Case U.S. Partner Manufactures, sells and distributes products Multinational - Multiple U.S./Non-U.S. Affiliates Owns valuable IP both within the U.S. and outside the U.S. Has an overall foreign loss ( OFL ) Has restructured its U.S. and Non-U.S. groups over time to better align its businesses Non-U.S. Partner Primary operations are outside the U.S. Owns complementary businesses and IP Parties believe significant synergies available through a business combination Property Transfers U.S. Partner Non-U.S. JV Non-U.S. Partner Contribution of property by U.S. Partner, and other property by Non-U.S. Partner. U.S. Partner and Non-U.S. Partner share income and other income in accordance with Agreement. 5

6 Pre- and Post-Taxpayer Relief Act of 1997 Prior to the Taxpayer Relief Act of 1997, section 1491 generally imposed a 35% excise tax on any built-in gain in property contributed by a U.S. person to a foreign partnership - General exception if taxpayers elected to apply section 367 rules, or to treat the transfer as fully taxable - Excise tax, not an income tax, so no basis step-up on gain Taxpayer Relief Act of 1997 replaced sections 1491 through 1494 (and section 1057) with: - Section 721(c), providing regulatory authority to turn off section 721(a) nonrecognition treatment upon the transfer of appreciated property to a partnership with foreign partners - Section 367(d)(3), providing regulatory authority to treat a transfer to a partnership of section 936(h)(3)(B) intangible property as subject to the section 367(d) rules - Imposed enhanced reporting under sections 6038, 6038B and 6046A. 6

7 Sections 721(a) and 704(c) Section 721(a) provides that no gain or loss will be recognized by a partnership or its partners by reason of a contribution of property to the partnership in exchange for an interest therein. Section 704(c) requires built-in gains or losses in property contributed to a partnership when recognized to be allocated to the contributing partner Regulations under section 704(c) provide three separate methods for allocating gains and ongoing amortization/depreciation from built-in-gain and built-in-loss property: General exception if taxpayers elected to apply section 367 rules, or to treat the transfer as fully taxable - Traditional Method - Traditional With Curative Allocations - Remedial Method The partnership may apply a different method on a property-by-property basis All three methods are subject to an anti-abuse rule The intent of section 704(c) may be restricted in part by application of the ceiling rule, which, under the traditional method, limits such allocations to gain and loss items from the property itself 7

8 Pre-Notice Analysis: Normal Rules Applied Regardless of Control or Related Foreign Partner Facts USP, a U.S. corporation, wholly owns FS, a foreign corporation. USP and FS contribute property to PRS, a partnership. USP contributes Asset A, with a large amount of builtin gain. FS contributes Asset B. In cases of IRS concern, Asset A could be IP and used in disregarded license to Foreign Ops with e.g. hightaxed income allocated to FS and low-taxed to USP. Pre-Notice Analysis The contribution of Asset A does not result in gain recognition under section 721(a). PRS could use one of three methods (i.e., traditional method, traditional method with curative allocations, or remedial method), subject to certain anti-abuse rules, to account for the built-in gain of Asset A. Following the contribution to the partnership, the contributing partner recognizes income attributable to its partnership interest. The timing of recognition of the built-in gain in the asset depends on the section 704(c) method chosen. Asset B USP FS PRS Asset A Value - $100M Basis - $0 8

9 Notice Reasons for the Notice Treasury and the IRS have become aware that certain taxpayers purport to be able to contribute, consistently with sections 704(b), 704(c), and 482, property to a partnership that allocates the income or gain from the contributed property to related foreign partners that are not subject to U.S. tax. Many of these taxpayers choose a section 704(c) method other than the remedial method and/or use valuation techniques that are inconsistent with the arm s length standard. Treasury and the IRS have also become aware that certain taxpayers may be valuing property contributed to partnerships, or the property or services involved in related controlled transactions, in a manner contrary to section 482, and that [a]s a result, partnership interests or consideration received in related controlled transactions also may be incorrectly valued, thereby reducing the amount of income or gain allocated to U.S. partners. NOTE: The valuation concerns as a practical matter arise only for IP. 9

10 Notice Background Notice , issued on August 6, 2015, announces the intent to issue regulations under section 721(c) to ensure that, when a U.S. person transfers certain property to a partnership that has foreign partners related to the transferor, income or gain attributable to the property will be taken into account by the transferor either immediately or periodically (through the remedial section 704(c) method). The new regulations will have two main features: - Significant new restrictions will apply if the U.S. partner and related foreign person together own more than 50 percent of the interests in partnership capital, profits, deductions or losses, and the U.S. partner contributes built-in gain property to the partnership. - Immediate gain recognition will be required under section 721(c) on the contribution unless the partnership adopts the Gain Deferral Method. Notice also states that section 482 regulations will be issued to specify transfer pricing methods applicable to controlled transactions involving related-party partnerships. These specified methods, which may apply to partnership contributions, partnership distributions, and partnership allocations, will mirror the methods currently prescribed for cost-sharing arrangements and will include a periodic trigger feature similar to the cost-sharing periodic trigger. 10

11 Notice Section 721(c) Regulations Gain Deferral Method imposes 5 requirements 1. The partnership adopts the remedial allocation method for built-in gain with respect to all Section 721(c) Property contributed to the partnership pursuant to the same plan by a U.S. Transferor and all other related U.S. Transferors 2. The partnership allocates all items of section 704(b) income, gain, loss, and deduction with respect to that Section 721(c) Property in the same proportion during any taxable year in which there is remaining built-in gain with respect to an item of Section 721(c) Property 3. Certain reporting requirements are satisfied; 4. U.S. Transferor recognizes built-in gain upon certain Acceleration Events 5. The Gain Deferral Method is adopted for all Section 721(c) Property subsequently contributed by the U.S. Transferor and related U.S. Transferors until the earlier of: a. the date when no built-in gain remains with respect to any Section 721(c) Property to which the Gain Deferral Method first applied, or b. 60 months after the initial contribution of Section 721(c) Property to which the Gain Deferral Method first applied 11

12 Notice Proportionate Allocations Section 721(c) Property does not include: - cash equivalents - any security within the meaning of section 475(c)(2), without regard to section 475(c)(4) - any item of tangible property with Built-in Gain that does not exceed $20,000 Proportionate Allocations Requirement - Prohibits special allocations of particular section 704(b) items (income, gain, loss, deduction) with respect to an item of Section 721(c) Property - The determination is made on a property-by-property basis - Regulatory allocations and allocations of foreign tax credits required under the section 704(b) regulations may require certain items to be shared in different proportions regulations will need to coordinate these rules with the same proportion rule 12

13 Notice Acceleration Events A U.S. Transferor must recognize all (or, in some instances, a portion of) the remaining built-in gain upon an Acceleration Event - any transaction that would either reduce the remaining built-in gain that a U.S. Transferor would recognize under the Gain Deferral Method if the transaction had not occurred, or that could defer the recognition of such gain - any party fails to comply with any Gain Deferral Method requirement Certain transactions are excepted: - U.S. Transferor transfers of an interest in a Section 721(c) Partnership to a domestic corporation in a section 351(a) or section 381(a) transaction or a Section 721(c) Partnership transfers an interest in a lower-tier partnership that owns Section 721(c) Property to a domestic corporation in a section 351(a) transaction, provided that in both cases the parties continue to apply Gain Deferral Method by treating the transferee domestic corporation as the U.S. Transferor for all purposes of the Notice - Section 721(c) Partnership transfers Section 721(c) Property to a domestic corporation in a section 351(a) transaction - Section 721(c) Partnership transfers Section 721(c) Property (or an interest in a partnership that owns Section 721(c) Property) to a foreign corporation in a transaction described in section 351(a), to the extent the Section 721(c) Property is treated as being transferred by a U.S. person (other than a domestic partnership) pursuant to 1.367(a)-1T(c)(3)(i) or (ii). 13

14 Notice Observations/Some Open Questions Acceleration Events - Because the regulations appear to measure built-in gain at the level of the Section 721(c) Partnership, would a distribution of Section 721(c) Property to the U.S. Transferor that contributed such property be an Acceleration Event, even though the built-in gain is preserved in the hands of the U.S. Transferor? Third Party JVs - Although the Notice is targeted at partnerships between related taxpayers, the rules encompass all controlled partnerships, which could include some third-party joint ventures. Deemed Partnerships - It is not always clear whether the economic relationship between taxpayers constitutes a partnership for U.S. federal income tax purposes or whether a particular taxpayer s interest in a partnership is debt or equity. With the requirement of immediate gain recognition turning on whether a relationship is a tax partnership and who the partners are, the stakes surrounding these determinations have been raised. Technical Terminations - Taxpayers will need to carefully monitor transfers of partnership interests that could result in a technical termination of a partnership in existence before the date of the Notice, which could cause a deemed contribution to a new partnership of built-in gain assets contributed to the old partnership prior to the date of the Notice. 14

15 Notice Observations/Some Open Questions (Cont d) Subsequent Contribution Rule - This rule forces section 721(c) Partnerships to use the GDM for subsequent contributions. Is such inflexibility necessary? Remedial Allocation Requirement: - How would the Remedial Allocation Requirement work in situations where the section 197 regulations would prevent non-contributing partners from receiving remedial allocations of amortization from the Section 721(c) Property (e.g., due to the Section 721(c) Property being subject to the anti-churning rules under section 197(f)(9) and the non-contributing partner being related to the Section 721(c) Partner)? - Should the remedial allocation method apply to reverse section 704(c) gain arising from revaluation events of the Section 721(c) Partnership? - Would allocations of remedial income and deductions result in mirroring separate categories under the section 704(b) regulations governing allocations of creditable foreign tax expenditures (CFTEs)? 15

16 Notice Observations/Some Open Questions (Cont d) The Proportionate Allocations Requirement: - Would regulatory allocations that cause allocations of partnership items with respect to Section 721(c) Property not to be in the same proportion result in a violation of the Proportionate Allocations Requirement? - Would allocations based on separate activities and under the section 704(b) regulations required CFTEs to be shared per CFTE categories violate the Proportionate Allocations Requirement? - When do allocations of section 704(b) net (vs. gross) income to support a preferred distribution right violate the Proportionate Allocations Requirement? - Would guaranteed payments be treated as a distributive share of partnership income, gain, loss, and deduction for purposes of the Proportionate Allocations Requirement, potentially causing a violation thereof? 16

17 Notice Example USP, a domestic corporation, wholly owns FS, a foreign corporation USP (U.S.) Stock PRS Interest USP and FS own all of the interests in PRS, which was formed prior to the effective date of Notice USP s management concludes that USP should not hold the PRS interest directly and causes USP to contribute the PRS interest to U.S. Sub in exchange for U.S. Sub Stock FS (Foreign) 40% PRS (U.S.) USP (U.S.) U.S. Sub (U.S.) FS (Foreign) U.S. Sub (U.S.) 40% 60% PRS (U.S.) 17

18 Notice Example (Cont d) PRS terminates for tax purposes under section 708(b)(1)(B) USP (U.S.) Deemed Transactions: - PRS contributes its assets to new PRS in exchange for New PRS interests and New PRS assumption of PRS liabilities - New PRS liquidates, distributing New PRS interests to FS and to U.S. Sub Treatment of this transaction? What happens if PRS merely registers as a foreign partnership? New PRS Interest FS (Foreign) Assets PRS (U.S.) PRS (U.S.) U.S. Sub (U.S.) New PRS Interest New PRS Interests 18

19 Notice Additional Rules De minimis rule The regulations will include a de minimis rule providing that section 721(a) (if otherwise applicable) will continue to apply (without regard to whether the requirements of the Gain Deferral Method are satisfied) if during the U.S. Transferor s taxable year (1) the sum of the Built-In Gain with respect to all Section 721(c) Property contributed in that year to the Section 721(c) Partnership by the U.S. Transferor and all other U.S. Transferors that are Related Persons does not exceed $1 million, and (2) the Section 721(c) Partnership is not applying the Gain Deferral Method with respect to a prior contribution of Section 721(c) Property by the U.S. Transferor or another U.S. Transferor that is a Related Person. Anti-Abuse Rule If a U.S. Transferor engages in a transaction (or series of transactions) with a principal purpose of avoiding the application of the regulations described in this notice, then, for purposes of those regulations, the transaction (or series of transactions) may be disregarded or the arrangement may be recharacterized (including disregarding an intermediate entity) in accordance with its substance. Tiered Partnerships Notice can apply to transactions involving tiered partnerships. 19

20 Notice Valuation Issues The Notice also addresses Treasury and IRS concerns that taxpayers may be valuing property contributed to partnerships in a manner contrary to section Inappropriately low valuation with respect to assets contributed by U.S. partner - Income shifted to non-u.s. related person through section 704(c) allocations IRS has broad authority under section 482 to make allocations to properly reflect the economics of a controlled transaction The Notice announces an intent to implement regulations to augment section 482 rules applicable to partnerships - Intent to apply the methods specified under the platform contribution regulations 20

21 Notice Effective Dates Basic Rules immediate gain recognition or the use of the gain deferral method are immediately effective - The new rules requiring immediate gain recognition under section 721(c) or the adoption of the Gain Deferral Method on transfers of appreciated property to a section 721(c) partnership will apply to transfers occurring on or after August 6, The rules also apply to post-effective date check-the-box elections, even if retroactive to before the Notice Additional components are deferred until the publication of regulations - The new reporting requirements in section 4.06(2) of the Notice, and statute of limitations provisions in section 4.06(3) of the Notice, will be effective for transfers occurring on or after the date of publication of the Treasury Regulations. - Final Regulations? Proposed? Temp? The section 482 and section 6662 regulations described in the Notice will apply to transactions occurring on or after the date regulations are published. 21

22 Example 1 USP, a domestic corporation, wholly owns FS, a foreign corporation Patent FMV - $1,200,000 A/B - $0 Security FMV - $100,000 A/B - $20,000 Machine FMV - $200,000 A/B - $600,000 USP PRS FS $1,500,000 Cash USP and FS form a new partnership, PRS FS contributes cash of $1.5 million to PRS, and USP contributes the following three assets: - a patent with an FMV of $1.2 million and an adjusted basis of $0 - a security with an arm's length price of $100,000 and an adjusted basis of $20,000 - a machine with an arm's length price of $200,000 and an adjusted basis of $600,000 22

23 Example 1 (Cont d) Because the patent has built-in gain, it is Section 721(c) Property Patent FMV - $1,200,000 A/B - $0 Security FMV - $100,000 A/B - $20,000 Machine FMV - $200,000 A/B - $600,000 USP PRS FS $1,500,000 Cash Although the security also has built-in gain, it is excluded (asset described in section 475(c)(2)) The machine has a built-in loss and is therefore not Section 721(c) Property The de minimis rule does not apply - the sum of the built-in gain is $1.2 million, which exceeds the $1 million de minimis threshold - The built-in loss in the machine does not factor into determining whether the contribution is below the de minimis threshold. Section 721(a) does not apply to USP s contributions of the patent to PRS, unless Gain Deferral Method is applied. 23

24 Example 2 In Year 1, USP contributes Asset 1 with more than $1 million BIG USP PRS elects the Gain Deferral Method with respect to Asset 1 (remedial allocations, proportional allocations, reporting obligations, etc.). Income, gain, deduction and loss with respect to Asset 1 is 60% to USP and 40% to FS Year 1 Asset 1 >$1M BIG Year 4 Asset 2 $100,000 BIG FS In an unrelated transaction in Year 4, USP contributes Asset 2 with $100,000 BIG PRS elects remedial method for Asset 2 Income, gain, and loss with respect to Asset 2 are allocated 20% to USP and 80% to FS, but deductions are 90% to USP and 10% to FS. PRS Because of the differing allocations, the Gain Deferral Method is not met with respect to Asset 2, and USP must recognize the Built-in Gain with respect to Asset 2. Additionally, because Gain Deferral Method does not apply to Asset 2, an Acceleration Event is deemed to occur with respect to Asset 1 and USP must recognize any remaining BIG with respect to Asset 1. 24

25 Example 3 The facts are the same as in Example 2 except that USP does not contribute Asset 2 in Year 4 Year 1 Asset 1 >$1M BIG USP FS In Year 3, the partners amend the partnership agreement so that all items of income, gain, deduction, and loss with respect to Asset 1 are now allocated 30% to USP and 70% to FS Assume the amendment is accompanied by arm s length consideration and allocations have substantial economic effect - Is this a sale of a p-ship interest? PRS Because each section 704(b) item continues to be allocated in the same proportion to each partner, the Gain Deferral Method will continue to apply 25

26 Example 4 Year 1 Asset 1 721(c) property >$1M BIG USP FS USX Year 1 In Year 1, USP contributes Asset 1 more than $1 million BIG to PRS in which FS, a related person, and USX, an unrelated U.S. person, are also partners The parties elect and properly apply the Gain Deferral Method with respect to Asset 1 Year 3 USP PRS Assets (including interest in PRS) USP 381 Transaction USS USX In Year 3, USP transfers all of its assets, including its interest in PRS, to USS, a domestic corporation, in a transaction to which section 381(a) applies In Year 9 (a year in which there is remaining Built-In Gain with respect to Asset 1), PRS distributes Asset 1 to FS Year 9 FS Asset 1 PRS 26

27 Example 4 (Cont d) Year 1 Asset 1 USP FS USX Year 3 Although USP will no longer recognize any remaining BIG with respect to Asset 1 following the transfer to USS, USS is a successor U.S. Transferor PRS Year Transaction USP USS Assets (including interest in PRS) USP Year 9 FS Asset 1 PRS USX Therefore, provided the requirements of Gain Deferral Method continue to be satisfied including treating USS as the U.S. Transferor, the transfer to USS is not an Acceleration Event Year 9 Although section 704(c)(1)(B) does not apply to the distribution, the distribution is an Acceleration Event because USS will not recognize any remaining BIG with respect to Asset 1 USS must recognize gain equal to the remaining BIG that would have been allocated to USS if PRS had sold Asset 1 immediately before the distribution 27

28 Example 5 Year 1 Asset 1 USP PRS FS USX The facts are the same as in Example 4 except that in Year 3, PRS contributes Asset 1 to FC, a foreign corporation in a section 351(a) transaction. There is no distribution in Year 9. For purposes of section 367(a) and (d), each partner in PRS that is a U.S. person is treated as having transferred its share of Asset 1 to FC (see Treas. Reg (a)-1T(c)(3)(i)). Year 3 USP FS USX An Acceleration Event occurs, but not to the extent of USP's and USX's shares of the Section 721(c) Property The FC stock received by PRS in the transaction is not subject to the Gain Deferral Method. PRS Asset 1 FS 28

29 Section 956 Aggregate or Entity?... Aggregate 29

30 Section Policy Considerations Section 956 is intended to limit the ability to defer earnings and avoid immediate taxation. The legislative history provides that the purpose of section 956 is to prevent repatriation of income to the U.S. in such a way that avoids U.S. Federal income taxation. Section 956 subjects certain types of investments in the U.S. to current taxation because they were thought to be substantially equivalent to dividends to the shareholders. 30

31 Section 956 General Rules A U.S. shareholder of a CFC generally must include in income its Section 956 amount for the taxable year under Section 951(a)(1)(B). U.S. shareholder s Section 956 amount is generally equal to the lesser of its pro rata share of: - the amount of U.S. property held (directly or indirectly) by the CFC; or - the CFC s earnings and profits ( E&P ), reduced to account for any PTI. Generally, section 956 measures the CFC s investment in U.S. property by reference to the basis of that property, and for this purpose averages the amounts outstanding at the end of each quarter of a tax year. 31

32 Section 956 Definition of U.S. Property Under section 956(c), U.S. property includes: - tangible property located in the U.S.; - stock of a related domestic corporation; - obligations of related U.S. persons IRS takes the position that this includes accrued and unpaid interest thereon under CCA ; - certain intellectual property used in the U.S.; and - trade or service receivables acquired from related U.S. persons and due from U.S. persons. In addition, if a CFC guarantees or pledges its assets to secure the obligation of a U.S. person, the CFC is treated as holding that obligation. The same treatment may apply under certain conditions if a U.S. shareholder pledges most or all of the stock of the CFC. Section 956(c)(2) provides certain exceptions to the definition of U.S. property. 32

33 Section Anti-Avoidance Rule - Before the New Temporary Regulations The anti-avoidance rule of Temp. Reg T(b)(4) provides that a CFC is considered to hold indirectly, investments in U.S. property acquired by any other foreign corporation that is controlled by the CFC, if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) such other foreign corporation is to avoid the application of section 956 with respect to the CFC. 33

34 Application of Section 956 through Partnerships Rev. Rul The IRS took an aggregate approach in addressing the treatment of a CFC s investment in U.S. property through a partnership. - Facts: S, a CFC, owned a 25% interest in PRS, which is either a foreign or domestic partnership. The remaining 75% of PRS was owned by unrelated parties. PRS s assets included U.S. real estate, which constitutes U.S. property under Section Ruling: S is considered to hold a 25 percent interest in the U.S. real estate owned by PRS. The amount taken into account for purposes of Section 956 is 25% of PRS s adjusted basis in the land, limited by S s total basis in PRS. FMV = 50 Basis = 10 P (U.S.) S (Foreign) PRS U.S. Real Estate FMV = 200 Basis = 80 Unrelated (Foreign) 34

35 Application of Section 956 through Partnerships Treas. Reg (a)(3) Rev. Rul is now incorporated into the Brown Group regulations in Treas. Reg (a)(3), which take an aggregate approach of partnerships and treat a CFC-partner as owning its pro rata share of the assets held by the partnership for purposes of determining whether the CFC holds U.S. property. CFC1 U.S. Parent USP CFC2 - Here, the partnership interests in USP held by CFC1 and CFC2 are not section 956 property. U.S. Property - However, under Treas. Reg (a)(3), a CFC partner in a partnership that owns U.S. property is 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 U.S. property. 35

36 Application of Section Loan to Foreign Partnership Background An obligation of a U.S. person is U.S. property for purposes of section 956(a) and a U.S. person includes domestic partnerships. - Thus, a loan from a CFC to a domestic partnership results in the CFC holding an obligation of a U.S. person, and therefore U.S. property. - This rule treats the partnership as an entity for this purpose rather than an aggregate of its partners. In the preamble to proposed regulations under section 954(i), the IRS requested comments whether a loan from a CFC to a foreign partnership that has one or more U.S. partners results in the CFC holding an obligation of a U.S. person for purposes of Section

37 Application of Section Loan to Foreign Partnership Commentary IRS requested comments on whether CFC should be treated as making a loan to USP, triggering a section 956 inclusion. U.S. Parent The NYSBA issued comments in which it argued that because the Subpart F regime treats a domestic partnership as a U.S. person, Subpart F similarly should treat a foreign partnership as a separate entity that s not a U.S. person. Thus, the CFC generally should not be treated as holding an obligation of a U.S. person for purposes of section 956. USS USP CFC NYSBA acknowledged, however, that to the extent FP invested the proceeds in U.S. property, including any loan of the proceeds to USP, or distributed the proceeds to USP, and one of the principal purposes of the transaction was the avoidance of section 956, it would be appropriate for the IRS to treat CFC as holding U.S. property. 37

38 Application of Section 956 to Partnerships Temporary and Proposed Regulations On September 2, 2015, Treasury released temporary and proposed regulations addressing application of section 956 to partnership transactions. The temporary regulations address application of the anti-abuse rule to partnership entities and partnership distributions funded by CFCs. - The temporary regulations are effective with respect to taxable years of CFCs ending on or after September 2, The temporary regulations expire in three years if not finalized under the sunset provisions. The proposed regulations address, in part, whether the obligations of a non-u.s. partnership will be treated as U.S. property for purposes of section The proposed regulations are proposed to be effective with respect to taxable years of CFCs ending on or after the date final regulations are published, and taxable years of U.S. shareholders in which or with respect to which such taxable years end. 38

39 Application of Section 956 to Partnership Transactions Temporary Regulations The temporary regulations address Treasury and IRS concerns that taxpayers may be using partnerships to structure transactions that are similar to transactions addressed by Treas. Reg T(b)(4) - Treas. Reg T(b)(4) is currently applicable to transactions that involve foreign corporations that are controlled by a CFC and requires the IRS to exercise its discretion - Treasury and IRS were concerned with the following transactions: CFC funded loans CFC contributes cash to partnership Partnership loans cash to U.S. shareholder of the CFC Taxpayer position: CFC is treated as holding an interest in the obligation only to the extent of the CFC s interest in the partnership CFC funded distributions CFC lends (or guarantees loan) to foreign partnership Foreign partnership distributes proceeds to U.S. partner who is related to CFC Taxpayer position: Section 956 does not apply 39

40 Application of Section 956 to Partnership Transactions Temporary Regulations New Partnership Rule Treas. Reg T(b)(4) expanded to include transactions involving partnerships that are controlled by the CFC - U.S. property held indirectly by a CFC includes Property acquired by a partnership that is controlled by the controlled foreign corporation if the property would be United States property if held directly by the controlled foreign corporation, and a principal purpose of creating, organizing, or funding by any means (including through capital contributions or debt) the partnership is to avoid the application of section 956 with respect to the controlled foreign corporation. - Control CFC controls the foreign partnership if the CFC and the partnership are related within the meaning of 707(b) For purposes of determining whether two corporations are members of the same controlled group, section 267(c) principles apply Rule is self-executing (both with respect to transactions involving corporations and transactions involving partnerships) 40

41 Application of Section 956 to Partnership Transactions Temporary Regulations New Partnership Rule FS1 has substantial e&p FS1 contributes $600 to FP in exchange for a 60% interest U.S. Parent 1 USP contributes OUS real property valued at $400 in exchange for a 40% interest FS1 40% OUS RP $400 value% FP lends $100 to USP - FS1 is treated as holding U.S. property of $60 pursuant to Treas. Reg (a)(3). A principal purpose of organizing FP is to avoid section 956 with respect to FS1 1 60% FP (Foreign) 2 $100 Loan FS1 is treated as holding U.S. property of $100 - $60 under Treas. Reg (a)(3) - $40 under Temp. Treas. Reg T(b)(4)(i)(C) and (b)(4)(iii) Partnership Agreement No Special Allocations 41

42 Application of Section 956 to Partnership Transactions Temporary Regulations Partnership Distributions General Rule of Section T(b)(5) - An obligation of a foreign partnership held (or treated as held) by a CFC is treated as a separate obligation of a partner in the partnership if The foreign partnership distributes an amount of money or property to the partner The foreign partnership would not have made the distribution but for a funding of the partnership through the obligation The partner is related to the CFC within the meaning of section 954(d)(3) Amount of obligation - The lesser of (a) the amount of the partnership distribution that would not have been made but for such funding or (b) the amount of the obligation of the foreign partnership that is held (or treated as held) by the CFC 42

43 Application of Section 956 to Partnership Transactions Temporary Regulations Partnership Distributions USP wholly owns FS, a CFC USP owns a 70% interest in FP U.S. Parent UTP, a domestic corporation, owns the remaining 30% interest in FP FP borrows $100 from FS and distributes $80 to USP FP would not have made the distribution to USP but for the funding by FS 1 FS1 $100 Loan 70% FP (Foreign) 30% UTP (U.S.) A portion of the obligation that FS holds is treated as an obligation of USP The amount treated as an obligation of USP is the lesser of $80 (the amount of the distribution) or $100 (the amount of the obligation that is held by the CFC) 2 $80 Distribution Partnership Agreement No Special Allocations 43

44 Application of Section 956 to Partnership Transactions Proposed Regulations Treasury and IRS determined that failing to treat an obligation of a foreign partnership as an obligation of its partners could allow deferral of U.S. taxation of CFC earnings and profits in a manner inconsistent with the purposes of section 956 Areas of concern: - Potential ability of U.S. shareholder to access deferred CFC earnings loaned to a foreign partnership in which the U.S. shareholder is a partner without those earnings becoming subject to U.S. by causing the partnership to make a distribution Proposed regulations treat an obligation of a foreign partnership as an obligation of its partners, subject to an exception for obligations of foreign partnerships in which neither the lending CFC nor any person related to the lending CFC is a partner 44

45 Application of Section 956 to Partnership Transactions Proposed Regulations (b) A partner in a partnership is treated as holding its attributable share of any property held by the partnership (including partnership obligations) Attributable share is determined in accordance with the partner s liquidation value percentage the atom bomb approach - Liquidation Value - The amount of cash the partner would receive if immediately after the occurrence of the most recent revaluation event or, if none, immediately after the formation of the partnership, the partnership sold all of its assets for cash equal to the fair market value of such assets, satisfied its liabilities (other than certain contingent liabilities), paid an unrelated third party to assume its contingent liabilities in a fully taxable transaction, and then liquidated. - Liquidation Percentage The ratio of the liquidation value of the partner s interest in the partnership divided by the aggregate liquidation value of all of the partners interests in the partnership. Special allocations taken into account if the special allocation does not have a principal purpose of avoiding section

46 Application of Section 956 to Partnership Transactions Proposed Regulations (b) (Cont d) USP owns 100% of FS, a foreign corporation that is a CFC FS owns an interest in FP, a foreign partnership; an unrelated third party owns the rest of the interest in FP FP owns non-depreciable property with a basis of $100 the property would be U.S. property if held by FS directly At the close of the quarter, FS liquidation value percentage is 25% FS is treated as holding its attributable share of the property with an adjusted basis equal to its attributable share of FP s adjusted basis in the property - FS liquidation value percentage is 25% - FS attributable share of FP s adjusted basis is $25 - FS is treated as holding US property with an adjusted basis of $25 U.S. Parent FS 100% FP (Foreign) Partnership Agreement No Special Allocations FS Liquidation Value Percentage 25% UTP Non-U.S. Non-depreciable property A/B = $100 46

47 Application of Section 956 to Partnership Transactions Proposed Regulations (b) (Cont d) USP owns 100% of FS, a foreign corporation that is a CFC FS owns an interest in FP, a foreign partnership; an unrelated third party owns the rest of the interest in FP FP owns non-depreciable property with a basis of $100 the property would be U.S. property if held by FS directly Income with respect to U.S. property is specially allocated to FS - The special allocation does not have a principal purpose of avoiding section 956 FS s attributable share is determined in accordance with its special allocation - FS s special allocation percentage for U.S. property is 80% and its attributable share of FP s adjusted basis in the property is $80 - FS is treated as holding U.S. property with a basis of $80 U.S. Parent FS 100% FP (Foreign) Partnership Agreement 80% of the income with respect to U.S. property is allocated to FS UTP Non-U.S. Non-depreciable property A/B = $100 47

48 Application of Section 956 to Partnership Transactions Proposed Regulations (b) (Cont d) USP owns 100% of FS, a foreign corporation that is a CFC FS owns an interest in FP, a foreign partnership; USP owns the rest of the interest in FP FP owns property with an adjusted basis of $100; the property would be U.S. property if held by FS directly FP is anticipated to appreciate in value, but to generate relatively little income The partnership agreement specially allocates 80% of the income with respect to the property to USP and 80% of the gain with respect to the disposition of the property to FS. - The allocation does not have a principal purpose of avoiding the purposes of section 956 The partners attributable shares are determined in accordance with the special allocation - FS s attributable share of FP s property is 80% and its attributable share of FP s adjusted basis in the property is $80 - FS is treated has holding U.S. property with a basis of $80 100% FS U.S. Parent FP (Foreign) Partnership Agreement 80% of the income with respect to U.S. property is allocated to USP 80% of the gain with respect to the disposition of the property is allocated to FS Property A/B = $100 48

49 Application of Section 956 to Partnership Obligations Proposed Regulations (c) Obligations of a Foreign Partnership An obligation of a foreign partnership is treated as a separate obligation of each of the partners in the partnership to the extent of each partner s share of the obligation Partner s share of partnership obligation determined in accordance with the partner s interest in partnership profits - Preamble notes that the approach is consistent with the observation that, to the extent the proceeds are used by the partnership to invest in profit-generating activities, partners (including service partners) will benefit from the obligation to the extent of their interest in partnership profits - Share of obligation determined as of the close of each quarter of the CFC s taxable year Exceptions - Foregoing rules do not apply if neither the CFC, nor any person related to the CFC, is a partner in the partnership 49

50 Application of Section 956 to Partnership Transactions Proposed Regulations (c) Obligations of a Foreign Partnership USP owns 100% of FS, a foreign corporation that is a CFC USP also owns a 90% interest in the partnership profits of FP UTP X owns a 10% interest in the profits of FP FP borrows $100 from FS; FS basis in the obligation is $100 The $100 obligation is treated as the obligation of FS and UTP X to the extent of their respective interests in partnership profits - Unrelated lender exception does not apply - USP s share of the obligation is $90 because its share of profits is 90% - $90 of the obligation held by FS is treated as an obligation of USP and is US property - On the date the loan is made, FS is treated as holding $90 of U.S. property $100 Loan 100% FS U.S. Parent FP (Foreign) Partnership Agreement USP owns a 90% interest in partnership profits UTP X owns a 10% interest in partnership profits 90% Profits UTP X Non-U.S. 10% Profits 50

51 Application of Section 956 to Partnership Transactions Proposed Regulations (c) Obligations of a Foreign Partnership (Cont d) USP owns 40% of FS, a foreign corporation that is a CFC Unrelated third party Z, a U.S. person, owns the remaining 60% of FS USP also owns a 90% interest in the partnership profits of FP UTP X owns a 10% interest in the profits of FP FP borrows $100 from FS; FS basis in the obligation is $100 Unrelated lender exception applies - Neither FS nor any person related to FS (within the meaning of section 954(d)(3)) is a partner in the partnership - The obligation is treated as an obligation of a foreign partnership, not of a U.S. person - FS is not treated as holding U.S. property UTP Z (U.S.) $100 Loan 60% FS 40% U.S. Parent FP (Foreign) Partnership Agreement USP owns a 90% interest in partnership profits UTP X owns a 10% interest in partnership profits 90% Profits UTP X Non-U.S. 10% Profits 51

52 Application of Section 956 to Partnership Transactions Proposed Regulations (c) Obligations of a Foreign Partnership (Cont d) USP owns 100% of FS, a foreign corporation that is a CFC U.S. Parent USP also owns a 60% interest in the partnership profits of FP FS has a 30% interest in the partnership profits of FP USC, a U.S. corporation, has a 10% interest in the profits of FP FS Guarantees FP Debt 30% Profits 60% Profits USC (U.S.) 10% Profits FP borrows $100 from an unrelated person FS guarantees the obligation FP (Foreign) $100 Loan UTP Z (U.S.) Partnership Agreement USP owns a 60% interest in partnership profits FS owns a 30% interest in partnership profits UTP X owns a 10% interest in partnership profits 52

53 Application of Section 956 to Partnership Transactions Proposed Regulations (c) Obligations of a Foreign Partnership (Cont d) The $100 obligation is treated as the obligation of USP, FS and USC to the extent of their respective interests in partnership profits - Unrelated lender exception does not apply with respect to USP - USP s share of the obligation is $60 because its share of profits is 60%; FS s share of the obligation is $30 because its share of profits is 30%; USC s share of the obligation is $10 because its share of profits is 10% - FS, as guarantor, is treated as holding the obligations of USP and USC that it guaranteed The obligation of USC is not U.S. property The obligation of USP is U.S. property; therefore on the date FS guaranteed the debt, FS is treated as holding U.S. property of $60 FS Guarantees FP Debt 30% Profits U.S. Parent FP (Foreign) Partnership Agreement USP owns a 60% interest in partnership profits FS owns a 30% interest in partnership profits UTP X owns a 10% interest in partnership profits 60% Profits $100 Loan USC (U.S.) 10% Profits UTP Z (U.S.) 53

54 Application of Section 956 to Partnership Transactions Proposed Regulations (c) Obligations of a Foreign Partnership (Cont d) USP owns 100% of FS, a foreign corporation that is a CFC USP also owns a 70% interest in the partnership profits of FP UTP X has a 30% interest in the partnership profits of FP FP borrows $100 from FS and makes a distribution of $80 to USP - FP would not have made the distribution to USP but for the funding of FP by FS Unrelated lender exception does not apply with respect to USP An obligation of USP held by FS would be U.S. property USP s attributable share of the obligation is $70 USP s share of the obligation is the greater of (i) its share of the obligation ($70), or (ii) the lesser of (a) the distribution ($80), or (b) the amount of the obligation ($100). - Thus, on the date of the loan, FS is treated as holding US property of $80 FS $100 Loan U.S. Parent FP (Foreign) Partnership Agreement USP owns a 70% interest in partnership profits UTP X owns a 30% interest in partnership profits 70% Profits $$80 Distribution UTP X (U.S.) 30% Profits 54

55 Application of Section 956 to Partnership Transactions Proposed Regulations Pledges and Guarantees Current Rule - An obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor is considered for purposes of section 956 to be U.S. property held by the CFC Proposed Regulations - Any obligation of a U.S. person with respect to which a CFC or a partnership is a pledgor or guarantor (directly or indirectly) is considered for purposes of section 956 to be U.S. property held by the CFC, or the partnership, as the case may be. CFC that is a partner in the pledgor partnership is not itself treated as a pledgor solely as a result of its ownership of an interest in the partnership How does one treat the pledge of a partnership interest by a U.S. person that has a related CFC partner? 55

56 Application of Section 956 to Partnership Transactions Proposed Regulations (Cont d) Existing Pledges and Guarantees The proposed regulations are proposed to be effective with respect to pledges and guarantees entered into on or after the date published in the federal register A pledgor or guarantor is treated as entering into a pledge or guarantee when there is a significant modification of an obligation with respect to which it is a pledgor or guarantor on or after the date the regulations are published in the federal register 56

57 Application of Section 956 to Partnership Transactions Proposed Regulations Pledges and Guarantees USP owns 40% of FS, a foreign corporation that is a CFC Unrelated third party Z, a U.S. person, owns the remaining 60% of FS USP also owns a 90% interest in the partnership profits of FP UTP X owns a 10% interest in the profits of FP FP borrows $100 from FS; FS basis in the obligation is $100 Unrelated lender exception applies - Neither FS nor any person related to FS (within the meaning of section 954(d)(3)) is a partner in the partnership - The obligation is treated as an obligation of a foreign partnership, not of a U.S. person - FS is not treated as holding U.S. property UTP X (Non-U.S.) 30% FS 2 Pledge Assets as Security for Loan 70% Partnership Agreement No Special Allocations USP interest in partnership profits 90% U.S. Parent 90% FP (Foreign) 1 10% $100 Loan UTP Y (Non-U.S.) UTP Z 57

58 CFTE Allocation Regulations 58

59 CFTE Allocation Regulations IRS issued temporary regulations under section 704 addressing the proper allocation of creditable foreign tax expenditures ( CFTEs ) on February 3, 2016 (T.D. 9748). Existing CFTE allocation regulations provide a safe-harbor method for partnerships to allocate CFTEs. Allocations made in accordance with safe harbor method deemed to be in accordance with the partners interests in the partnership ( PIP ) and respected under section 704 Revised CFTE Allocation Regulations intended to improve the operation of the safe harbor Effective for taxable years beginning on or after January 1,

60 Highlights of CFTE Allocation Regulations Two new examples highlight the application of the inter-branch payment rules. - One of the new inter-branch payment examples (Example 37) addresses the effect of back-to-back, inter-branch payments on the allocation of CFTEs arising from the payment of withholding taxes. - The example clarifies that withholding taxes must be divided among the partnership s CFTE categories in proportion to the manner in which the partners share in the income relating to the payment giving rise to the withholding tax. - Thus, the example prohibits the partnership from splitting the withholding tax CFTE from the related income by means of a deductible payment between branches in different CFTE categories. 60

61 Example A B C 80% business X 10% business Y 10% business Z 10% business X 80% business Y 10% business Z 10% business X 10% business Y 80% business Z ABC $100,000 (Royalty) DEX DEY DEX (IP Owner) Country X taxes net income of $10,000 at 30% = $3,000 Net Income Tax to X $90,000 (Royalty) Country X imposes withholding on $90,000 paid to DEY at 10%= $9,000 Withholding Tax to X $80,000 (Royalty) Partnership agreement treats only $10,000 of gross income as attributable to the business X activity. Of the remaining $90,000 of gross income, partnership agreement treats $10,000 as attributable to business Y and $80,000 as attributable to business Z; country X taxes are allocated in accordance with which DE is considered to have paid the taxes for country X purposes, i.e., $3,000 of CFTEs are allocated 80/10/10 to A,B,C, respectively, and $9,000 of CFTEs are allocated 10/80/10 to A,B, and C, respectively (i.e., all $9,000 of withholding tax CFTEs are allocated to the business Y CFTE category). Allocation of CFTEs related to Country X withholding tax are not within the safe harbor. According to the example: Because the $90,000 on which the country X withholding tax is imposed is split between the business Y CFTE category and the business Z CFTE category, those withholding taxes are allocated on a pro rata basis, $1,000 [$9,000 x ($10,000/$90,000)] to the business Y CFTE category and $8,000 [$9,000 x ($80,000/$90,000)] to the business Z CFTE category. 61