Comments Regarding the Application of Section 470 to Partnerships Solely as a Result of Section 168(h)(6)

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1 July 26, 2006 The Honorable Charles E. Grassley Chairman Senate Finance Committee 219 Senate Dirksen Office Building Washington, D.C The Honorable Max Baucus Ranking Minority Member Senate Finance Committee 219 Senate Dirksen Office Building Washington, D.C The Honorable William M. Thomas Chairman House Ways and Means Committee 1102 Longworth House Office Building Washington, D.C The Honorable Charles B. Rangel Ranking Minority Member House Ways and Means Committee 1102 Longworth House Office Building Washington, D.C Re: Comments Regarding the Application of Section 470 to Partnerships Solely as a Result of Section 168(h)(6) Dear Chairmen and Ranking Members: The American Institute of Certified Public Accountants (AICPA) is pleased to take this opportunity to submit the following comments regarding the application of section 470 to certain partnerships. The AICPA is the national, professional association of CPAs, with approximately 350,000 members, including CPAs in business and industry, public practice, government, and education; student affiliates; and international associates. Our members advise clients on federal, state, and international tax matters and prepare income and other tax returns for millions of taxpayers. They provide services to individuals, not-for-profit organizations, small and mediumsized businesses, as well as America s largest businesses. It is from this broad perspective that we offer our thoughts today. Internal Revenue Code section 470 is a loss disallowance provision primarily designed to address concerns with certain sale-in, lease-out (SILO) transactions considered abusive. However, the impact of section 470 extends far beyond these SILO transactions to disallow losses whenever a taxable and tax-exempt party form a partnership and choose to share in the performance of the partnership in a disproportionate manner. If left unchanged, section 470 may have a chilling impact on tax-exempt investment in legitimate business transactions, and will leave taxpayers and their advisors with a high degree of tax uncertainty. The AICPA suggests that the reference to section 168(h)(6) be removed and replaced with a broad anti-abuse provision to deter taxpayers from entering into any arrangement, including a partnership, that is the same or substantially similar to the transactions at which section 470 was targeted. Alternatively, we recommend providing an exception for partnerships which can demonstrate, based on facts and circumstances, that they have not been formed or availed of to avoid the purpose of section 470. We believe that either approach reduces much of the complexity and uncertainty, while continuing to apply section 470 in appropriate situations.

2 * * * * * We would be pleased to discuss this matter further with you or any member of your staff at any time. We also would be pleased to work with your staff on clarifying other aspects of how section 470 was intended to apply to partnerships. If you have any questions, please contact me at (402) , or tpurcell@creighton.edu; Deborah A. Fields, Chair of the Partnership Taxation Technical Resource Panel, at (202) , or dafields@kpmg.com; or Marc A. Hyman, AICPA Technical Manager, at (202) , or mhyman@aicpa.org. Thank you very much for your assistance with this important matter. Sincerely, Thomas J. Purcell III, Chair AICPA Tax Executive Committee Cc: Members of the Senate Finance Committee Members of the House Ways & Means Committee Thomas A. Barthold, Acting Chief of Staff (JCT) Cecily W. Rock, Senior Legislation Counsel (JCT) E. Ray Beeman, Legislation Counsel (JCT) Kolan Davis, Staff Director & Chief Counsel (SFC) & Tax Aide for Sen. Grassley Mark Prater, Chief Tax Counsel (SFC) Patrick G. Heck, Chief Tax Counsel (SFC) & Tax Aide for Sen. Baucus Robert Winters, Chief Tax Counsel (HWM) & Tax Aide for Rep. Thomas John Buckley, Chief Tax Counsel (HWM) Jon Sheiner, Tax Aide for Rep. Rangel Eric Solomon, Acting Assistant Secretary (Tax Policy), U.S. Treasury 2

3 AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS COMMENTS REGARDING THE APPLICATION OF SECTION 470 TO PARTNERSHIPS SOLELY AS A RESULT OF SECTION 168(h)(6) Prepared by the AICPA Partnership Taxation Technical Resource Panel and Approved by the AICPA Tax Executive Committee Submitted to Congress July 26,

4 AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS COMMENTS REGARDING THE APPLICATION OF SECTION 470 TO PARTNERSHIPS SOLELY AS A RESULT OF SECTION 168(h)(6) EXECUTIVE SUMMARY Enacted by the American Jobs Creation Act of 2004 (Pub. L ), Internal Revenue Code section is a loss disallowance provision primarily designed to address concerns with certain sale-in, lease-out (SILO) transactions considered abusive. However, by referencing section 168(h)(6), the impact of section 470 extends far beyond these SILO transactions to disallow losses whenever a taxable and tax-exempt party form a partnership and choose to share in the performance of the partnership in a disproportionate manner. If left unchanged, section 470 may have a chilling impact on tax-exempt investment in legitimate business transactions, and will leave taxpayers and their advisors with a high degree of uncertainty. The AICPA suggests that the reference to section 168(h)(6) be removed and replaced with a broad anti-abuse provision to deter taxpayers from entering into any arrangement, including a partnership, that is the same or substantially similar to the transactions at which section 470 was targeted. Alternatively, we recommend providing an exception for partnerships which can demonstrate, based on facts and circumstances, that they have not been formed or availed of to avoid the purpose of section 470. We believe that either approach reduces much of the complexity and uncertainty, while continuing to apply section 470 in appropriate situations. BACKGROUND Section 848 of the American Jobs Creation Act of 2004, Pub. L. No , enacted on October 22, 2004, introduced section 470 which creates new limitations on the deductibility of losses relating to tax-exempt use property. Subject to limited exceptions, section 470(a) provides that a tax-exempt use loss is not allowed for any tax year. Disallowed losses are treated as deductions with respect to the property in the next tax year under section 470(b). Section 470(c)(1) defines tax-exempt use loss with respect to any taxable year as the amount (if any) by which the sum of (1) the aggregate deductions (other than interest) directly allocable to tax-exempt use property, and (2) the aggregate deductions for interest properly allocable to the property, exceed the aggregate income from the property. Under section 470(c)(2), tax-exempt use property is defined by reference to section 168(h) with certain modifications. Section 168(h) generally defines tax-exempt use property as the portion of any tangible property, other than nonresidential real property, leased to a tax-exempt entity. For nonresidential real property, tax-exempt use property means the portion of the property leased 1 Section refers to sections of the Internal Revenue Code of 1986, as amended, unless otherwise indicated. 4

5 to a tax-exempt entity in a disqualified lease, as defined in section 168(h)(1)(B)(ii) (but only if more than 35 percent of the property is leased by disqualified leases). For these purposes, nonresidential real property includes residential rental property. See section 168(h)(1)(E). Tax-exempt use property does not include any portion of a property if such portion is predominantly used by the tax-exempt entity (directly or through a partnership of which such entity is a partner) in an unrelated trade or business with income subject to tax under section 511; however, use in an unrelated trade or business is determined without regard to section 514 for property owned by partnerships with both taxable and tax-exempt partners. Tax-exempt entity generally includes (1) organizations exempt from income tax under the Code; (2) certain foreign persons and entities; and (3) the United States and any State or political subdivision thereof. Section 168(h)(6)(F) provides that, unless an election is made to subject any gain recognized on any disposition of the interest in the entity to section 511, a tax-exempt entity includes any taxexempt controlled entity as defined in section 168(h)(6)(F)(iii). Under section 168(h)(6), if any property that is not otherwise tax-exempt use property under section 168(h) is owned by a partnership that has both a tax-exempt entity and a person who is not a tax-exempt entity as partners, and any allocation to the tax-exempt entity of partnership items is not a qualified allocation, an amount equal to the tax-exempt entity's proportionate share of the property generally is treated as tax-exempt use property. Under section 168(h)(6)(B), an allocation to a tax-exempt entity is a qualified allocation if the allocation (1) is consistent with the allocation to the entity of the same distributive share of each item of income, gain, loss, deduction, credit and basis throughout the entire period that the entity is a partner in the partnership and (2) has substantial economic effect within the meaning of section 704(b)(2). Section 168(h)(6)(E) provides that rules similar to those applicable to partnerships apply in determining whether property is tax-exempt use property in the case of any pass-thru entity other than a partnership and in the case of tiered partnerships and other entities. Recognizing that not all leases should be subject to section 470, Congress enacted subsection 470(d) that excludes from section 470 any lease of property if, in general: 1. Not more than an allowable amount of funds is subject to certain arrangements or set aside to satisfy the lessee s obligations or options under the lease (section 470(d)(1)); 2. The lessor makes a substantial equity investment in the leased property (section 470(d)(2)); 3. The lessee does not bear more than a minimal risk of loss with respect to the leased property (section 470(d)(3)); and 4. If the lease relates to property with a class life of more than 7 years, any option held by the lessee to purchase the property has a fair market value purchase price (section 470(d)(4)). Section 470(g) directs the Secretary to prescribe regulations, including regulations to allow, in appropriate cases, the aggregation of property subject to the same lease, and to determine interest expense allocations. 5

6 Section 470 generally applies to leases entered into after March 12, Although the effective date refers specifically to leases, the deduction limitation is intended to apply whether the taxexempt use property is treated as such under a lease or otherwise (e.g., by virtue of section 168(h)(6) 2 ). On February 14, 2005, the IRS issued Notice which describes transactions in which a taxpayer enters into a purported sale-leaseback arrangement with a tax-indifferent person in which substantially all of the tax-indifferent person s payment obligations are economically defeased and the taxpayer s risk of loss and opportunity for profit from a decrease or increase in the value of the leased property are limited. The Notice states that these transactions are tax avoidance transactions and identifies these and substantially similar transactions as listed transactions for purposes of sections 6111 and In recognition of the difficulty of applying the provisions of section 470 to partnerships and other pass-thru entities that are subject to section 470 because of section 168(h)(6), on March 10, 2005, the IRS issued Notice announcing that the Service will not apply section 470 to disallow losses associated with property treated as tax-exempt use property solely as a result of the application of section 168(h)(6) for taxable years that begin before January 1, More recently, on December 14, 2005, a letter to Secretary Snow from you, the Chairmen and Ranking Members of the Senate Committee on Finance and the House Committee on Ways & Means, indicated that the Committees and their staffs are working to develop legislation that would exempt non-abusive transactions engaged in by partnerships and other pass-thru entities from the scope of section 470. Your letter requested that the Secretary consider an extension of last year s relief. Two days later, on December 16, 2005, Notice extended the transition relief for one additional year, to taxable years that begin before January 1, If no legislation is enacted prior to next January, 2007, additional temporary relief will again become necessary. THE PURPOSE BEHIND SECTION 470 Section 470 was enacted in order to address Congressional concerns with certain SILO transactions. These transactions typically involve a tax-exempt entity selling property to a taxable entity that, in turn, leases the property back to the tax-exempt entity. The taxable entity would benefit from the cost recovery and interest expense deductions associated with the property, while any appreciation in the property s value would escape taxation and the taxexempt would continue to use the property. The legislative history indicates that section 470 was intended to address the ability of a taxexempt entity to inappropriately transfer certain tax benefits to a taxable entity. The legislative history goes on to note that, although leasing plays an important role in ensuring the availability of capital to businesses, certain transactions do not serve this role, but rather involve essentially an accommodation fee paid by a U.S. taxpayer to a tax indifferent party. Congress did not intend 2 Staff of Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108 th Cong. 426, n. 819 (2005) I.R.B I.R.B I.R.B

7 to inhibit legitimate commercial leasing transactions involving a significant and genuine transfer of the benefits and burdens of tax ownership between the taxpayer and the tax-exempt lessee. To this end, section 470 disallows tax-exempt use losses, but exempts in subsection 470(d) certain leases that do not create SILO concerns. It is our understanding that the scope of section 470 was broadened to include partnerships with tax-exempt partners and non-qualified allocations out of a concern that the same tax benefits could be shifted from the tax-exempt partners to taxable partners by using a partnership. However, based on the legislative history and the exception for certain non-abusive leases under section 470(d), not all partnerships between tax-exempt and taxable partners with non-qualified allocations should be subject to section 470. ANALYSIS The AICPA believes that the application of section 470 to partnerships merely because they have a combination of tax-exempt and taxable partners and non-qualified allocations is inappropriate. By referencing section 168(h)(6), section 470 subjects any partnership with both taxable and tax-exempt partners and disproportionate allocations to these loss disallowance rules, even partnerships that have not entered into any leasing arrangements with respect to their property and are not otherwise engaging in activities that raise SILO-related concerns. This is especially true given that a tax-exempt entity is defined to include the federal government, organizations that are exempt from income tax under the Code, certain foreign persons or entities, and certain tax-exempt controlled entities. Tax-exempt entities provide an important source of capital in our economy. Their ability to form partnerships with taxable entities promotes business activity. For example, partnerships are commonly formed between taxable and tax-exempt entities to invest in real estate. These partnerships often have allocations that provide for a preferential allocation to reflect the additional services or capital contributed by one partner, and a pro rata sharing of any residual income or loss. However, these allocations would not meet the definition of a qualified allocation resulting (inappropriately, we believe) in the disallowance of loss under section 470 even though they are driven by valid business concerns. Partnerships between tax-exempt entities and taxable entities should not be subject to the disallowance of loss merely because their allocations are not qualified, or contain special allocations. First, special allocations are typically economic arrangements that are bargained-for by the partners and are not tax motivated. Second, several other Code provisions, such as sections 704(b), 514(c)(9), and 7701(e)(2), police the ability of parties to inappropriately shift losses in a partnership, particularly between taxable and tax-exempt partners. Under section 704(b), to the extent that a taxable partner is allocated a disproportionately large share of losses, the partner must bear the burden of that allocation. In the context of partnerships with certain tax-exempt investors, section 514(c)(9) operates to prevent a partnership from allocating (on a percentage basis) more overall income to a partner that is a qualified organization than its smallest share of overall loss for any year. In addition, section 7701(e)(2) provides that an arrangement (including a partnership or other pass-thru entity), other than a service contract, is to 7

8 be treated as a lease if the arrangement is properly treated as a lease taking into account all relevant factors including who has physical possession of the property, who controls the property, and who bears the risk of loss with respect to the property. If the arrangement is properly treated as a lease under section 7701(e)(2) and the lease is to a tax-exempt entity, section 168(h)(1), and therefore section 470, will apply without implicating section 168(h)(6). Lastly, under newly-enacted section 4965, certain tax-exempt entities and their managers are subject to severe penalties for being a party to or approving of participation in a prohibited tax shelter transaction, which includes any listed transaction under Notice If these Code provisions are considered inadequate (which we do not believe they are), then more thought should be given to defining the abuse and the appropriate response in an effort to propose targeted legislation, rather than using section 470 to rake in non-abusive taxpayers and transactions. Furthermore, unintended consequences may result if section 470 continues to apply to partnerships as a result of section 168(h)(6). For example, if section 470 applies at the partnership level, a partnership with taxable and tax-exempt partners and non-qualified allocations may generate losses that are disallowed in year one. In year two, to avoid the application of section 470, the tax-exempt partners are redeemed out of the partnership and losses that would have been allocated to the tax-exempt partners may, in fact, become available to the taxable partners, a result that is clearly contrary to the purpose behind section 470. Primary Recommendation RECOMMENDATIONS To preserve the intent of section 470 and even enhance administrability, simplicity and to promote sound tax policy - the AICPA recommends amending section 470 by removing the reference to section 168(h)(6). In its place, we recommend substituting a broad anti-abuse rule, consistent with Notice , as a means of deterring taxpayers from entering into an abusive SILO arrangement or a substantially similar transaction. For example, the definition of taxexempt use property in section 470(c)(2) could be modified to exclude subsection (h)(6) from the reference to section 168(h) and instead include, as tax-exempt use property, property held in any arrangement that is substantially similar to an abusive sale-leaseback. Arrangements that are substantially similar to an abusive sale-leaseback could be defined to include those arrangements in which the form of the arrangement is not respected under substance over form principles. Alternative Recommendation If the reference to section 168(h)(6) is not removed, we recommend creating an exception for partnerships and similar arrangements which can demonstrate -- based on a facts and circumstances test -- that they were not formed or availed of to avoid the purpose of section 470. The exception could include an affirmative statement as to the purpose of section 470 and then provide a non-exclusive list of the facts and circumstances demonstrating that the arrangement was not formed or availed of to avoid that purpose, such as: 8

9 1. Any right granting the tax-exempt person (or person related to such tax-exempt person) to acquire the property (including an option or a right of redemption) is based upon the fair market value of the property (or is based on a formula that is intended to approximate the fair market value of the property) at the time of exercise, 2. In the case of a partnership between a tax-exempt entity and a taxable entity, the taxable entity has not entered into any arrangement the purpose of which is to defease substantially all of the taxable entity s risk of loss with respect to both its investment in the partnership and the activities of the partnership. 3. In the case of a partnership, allocations that are not qualified were made on an armslength basis between persons with sufficiently adverse interests for valid non-tax business reasons, such as to compensate a partner for services or the use of capital. We understand that the staff of the House Ways and Means Committee is currently considering an amendment to section 470 which would include a specific detailed exception for arrangements that is similar to the exception for certain leases under section 470(d) (Government Proposal). Although we would support the Government Proposal, we believe it will inevitably result in the continued inappropriate application of section 470 to some partnerships. Therefore, we suggest that in addition to the Government Proposal, consideration be given to providing the above exception based on a facts and circumstances test, so as to allow partnerships that are inappropriately subject to section 470 a final opportunity to be excluded. To the extent that a partnership was excluded from the application of section 470 based on the facts and circumstances test, the provision could include a requirement for the partnership to provide adequate disclosure on its tax return. Additional Concerns If section 470 is left unchanged, a number of ancillary issues should be addressed to allow taxpayers and practitioners to properly apply section 470, including: (1) defining pass-thru entities, tax-exempt use property, and tax-exempt use loss for section 470 purposes; (2) outlining how disallowed amounts are treated; and (3) explaining how section 470 applies to tiered-structures. The AICPA would be happy to submit additional comments addressing these issues and/or engage in informal dialogue. CONCLUSION We appreciate the relief that the IRS has granted taxpayers and practitioners with respect to the application of section 470. However, section 470 continues to be a source of concern and uncertainty. We hope that legislation can be enacted very soon so as to limit the application of section 470 to the intended targets. One possibility is to allow section 470 to continue to have very broad application and then craft numerous, very complicated exceptions to exclude certain partnerships. We disagree with this approach. First, legislation that is crafted to provide an exception for specific arrangements will inevitably result in the continued inappropriate application of section 470 to other arrangements with a less vocal or less favored constituency. Second, the complexity seems unwarranted given that the abusive arrangements are not always readily apparent. 9

10 We believe that when added to existing statutory and other authorities already in place for preventing abuse, either (1) a broad anti-abuse rule (together with an amendment to section 470 so that it would no longer be triggered by section 168(h)(6)), or (if no such amendment is forthcoming) (2) a rule that provides an exception for any arrangement that has not been formed or availed of to avoid the purpose of section 470, will provide better protection for the government and a more workable rule for taxpayers and practitioners. 10