Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances

Transcription

1 TAX LAW AND ESTATE PLANNING SERIES Tax Law and Practice Course Handbook Series Number D-463 Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 2016 Volume Two Co-Chairs Stephen D. Rose Eric B. Sloan Clifford M. Warren To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI order number , Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036

2 17 Tilting at Windmills: An Attempt to Bring Meaning to Determining Proportionate Ownership Under Code Sec. 902(c)(7) Christopher Trump Mark Graham Deloitte Tax LLP 2015 Deloitte Development LLC. All rights reserved. Mark Graham is a Senior Manager in the Deloitte Tax LLP Washington National Tax Office, and Chris Trump is a Principal in the Deloitte Tax LLP Washington National Tax Office. If you find this article helpful, you can learn more about the subject by going to to view the on demand program or segment for which it was written

3 2-252 Practising Law Institute

4 BIOGRAPHICAL INFORMATION Mark Graham is a Senior Manager in the Deloitte Tax LLP Washington National Tax Office, and Chris Trump is a Principal in the Deloitte Tax LLP Washington National Tax Office

5 Mark Graham and Christopher Trump analyze the different approaches taxpayers can adopt in determining stock ownership through a partnership for purposes of Code Sec. 902(c)(7) and posit that the weight of current authority suggests that Code Sec. 902(c)(7) ownership should be determined by reference solely to a partner s economic rights to underlying partnership assets

6 INTRODUCTION Section 902(c)(7) of the Internal Revenue Code ( the Code ) was enacted to address the question of whether a corporate partner can claim a deemed-paid foreign tax credit (FTC) with respect to dividends paid by a foreign corporation owned by the partnership. Although the issue was first addressed by the IRS and Treasury in 1971, decades before the enactment of Code Sec. 902(c)(7), significant uncertainty, compounded by changes in the domestic and international business landscape and an increase in the number of joint ventures entities, continued to exist leading to the enactment of Code Sec. 902(c)(7) in Thus, when introduced, Code Sec. 902(c)(7) was a welcome addition to the Code. However, as will become clear in the discussion below, even following the enactment of Code Sec. 902(c)(7), a number of important questions remain unanswered. Code Sec. 902(c)(7) provides that stock owned, directly or indirectly, by or for a partnership shall be considered as being owned proportionately by its partners. 1 Congress did not provide any direct guidance as to how a partner measures its proportionate ownership in such stock, instead leaving it to the IRS and Treasury to promulgate regulations in order to carry out the purposes of Code Sec. 902(c)(7), including to clarify which incidents of ownership should be considered in determining proportionate ownership. Thus, in order to apply Code Sec. 902(c)(7), a taxpayer presumably must divide the indirect ownership of a foreign corporation held by a partnership between its partners. It is unclear what facts should be used in determining how that division occurs. For example, what impact should the special allocation of dividend income have on that analysis? Should we consider the fact that the general partner makes all of the business decisions but is otherwise entitled to a minimal share of profits? Should we merely look to capital account balances or values that a partner has in its partnership interest? It does not seem that Congress was blind to these questions when it promulgated Code Sec. 902(c)(7). As noted above, regulatory authority was granted to the IRS and Treasury to publish regulations. However, the government has recently indicated that guidance in this area should not be expected by taxpayers anytime soon. 2 With the statute in mind, consider the following example, to which we will return to below, where a partnership, PRS, owns 100 percent of the total outstanding stock of Foreign Corp, a foreign corporation. PRS is

7 2-256 Practising Law Institute owned by three partners: Minority Limited Partner, Majority Limited Partner and General Partner, all domestic corporations. [Place Figure 1 here] Is it appropriate for Minority Partner to be entitled to deemed-paid FTCs associated with the dividend paid by Foreign Corp? CODE SEC. 902 AN OVERVIEW Code Sec. 901 allows a credit for foreign taxes paid by a U.S. taxpayer. In contrast, Code Sec. 902(a) allows domestic corporations to claim credits for foreign taxes paid by a U.S. taxpayer s foreign corporate subsidiaries. These deemed-paid credits are claimed by U.S. owners of foreign corporations at such time when their foreign corporate subsidiaries pay dividends of their foreign-taxed earnings and profits. 3 In order to claim a deemed-paid credit, a domestic corporation must directly own 10 percent of the voting stock of the distributing foreign corporation (the 10 Percent Vote Requirement ). If the domestic corporation does not meet the 10 Percent Vote Requirement, the deemed-paid credit is permanently disallowed and is instead allowed as a deduction against the earnings and profits of the foreign distributing corporation. 4 Deemed-paid foreign taxes under Code Sec. 902 may also be distributed from a lower-tier foreign corporation through tiers to a U.S. shareholder, provided that each such lower-tier foreign corporation is part of a qualified group. 5 A foreign corporation is part of a qualified group under Code Sec. 902(b) if (i) the recipient foreign corporation directly owns at least 10 percent of the voting stock of the distributing foreign corporation, and (ii) a domestic corporation indirectly owns at least five percent of the voting stock of the distributing and recipient foreign corporations. 6 THE 10 PERCENT VOTE REQUIREMENT Legislative History The predecessors to Code Secs. 901 and 902, which for the first time allowed a credit for foreign taxes, were enacted as part of the Revenue Act of When originally enacted, there were two separate statutes granting the direct FTC under Code Sec. 901 one provision for individuals 8 and another for corporations. 9 In contrast, there was only one statute intended for corporations which permitted an indirect tax credit. The provision was enacted as a subsection to the domestic provisions that permitted the filing of a consolidated 6

8 tax return. 10 Under this rule, a deemed-paid credit was only allowed to a U.S. corporation which own[ed] a majority of the voting stock of a foreign corporation. 11 It is not clear from the legislative history to the Revenue Act of 1918 why ownership of voting stock was required, or why a majority of a foreign corporation s voting stock needed to be owned in order to claim an FTC. Commentators have speculated that Congress may have believed that, since the provision was part of the consolidated return rules, a consolidated return-type tax credit should be allowed only where consolidated return-type ownership existed. 12 However, at the time the consolidated return rules were originally enacted, affiliated ownership existed where one corporation own[ed] directly or controls substantially all the stock of another corporation, without specifically referring to voting stock. 13 Thus, the requirement for majority voting stock ownership for the deemed-paid FTC is somewhat of a mystery. The majority vote threshold from 1918 was reduced to a 10- percent ownership requirement in the Revenue Act of The legislative history to the 1951 Act provided that the voting stock percentage was reduced because of the seemingly inappropriate result that prevented owners in a 50/50 joint venture to claim FTCs, and because many foreign jurisdictions imposed legal restrictions on foreign ownership of greater than 50 percent of an entity. 15 As to why Congress settled on a 10-percent threshold, the legislative history states that this was adopted for administrative reasons. 16 There is no legislative history to the subsequent iterations of the predecessor of Code Sec. 902 that explain why voting stock was an appropriate requirement. Perhaps when the deemed-paid foreign tax was later segregated from the consolidated group provisions, the voting stock requirement was merely a carryover. As noted above, Congress explicit policy for requiring an ownership threshold was administrative convenience. Implicitly, a 10- percent ownership threshold may be meant to curtail tax benefits associated with U.S. ownership of portfolio investments in foreign corporations. 17 And while 10 percent is an arbitrary ownership threshold (Why not nine? Or 11?), some threshold must be established, and today that threshold is 10 percent. In addition, and as discussed below, a more pronounced arbitrariness inherent in Code Sec. 902 is the determination of how a U.S. taxpayer meets the 10 Percent Voting Requirement such as when ownership is spread

9 among consolidated group members or when foreign voting stock is owned indirectly through a partnership. Administrative Guidance Since 1951, the IRS and Treasury have provided guidance on the application of Code Sec. 902 in a number of revenue rulings, 18 a few of which are helpful to understanding the application of the 10 Percent Vote Requirement in the context of Code Sec. 902(c)(7) and are discussed below. In Rev. Rul , the IRS considered whether a domestic corporation that owned 10 percent of the voting stock of a foreign corporation could claim a deemed-paid credit on a dividend from the foreign corporation distributed on its nonvoting stock. 19 The IRS ruled that an FTC was permitted in this circumstance, reasoning that [t]here is no requirement in section 902 or the regulations thereunder that for purposes of computing the foreign tax credit allowed under section 902 a dividend received means only a dividend paid on the voting stock of the foreign corporation. 20 Therefore, the dividends received can include dividends on both voting and nonvoting stock of the foreign corporation as long as the domestic corporation owns at least 10 percent of the foreign corporation s voting stock in the aggregate. The IRS contrasted this position with that in Rev. Rul , where a Code Sec. 902 deemed-paid FTC was disallowed to the domestic parent corporation receiving a dividend distribution directly from its second-tier foreign subsidiary because such parent corporation owned only nonvoting stock of such second-tier subsidiary. 21 Later, in Rev. Rul. 84-6, the IRS addressed whether the 10 Percent Vote Requirement was met where a foreign corporation had separate classes of voting stock outstanding in two situations. 22 The sole difference between the classes of stock in each case was the number of board members each class had the power to elect. The ruling concluded that the 10 Percent Vote Requirement should be determined based on the relative voting power of all outstanding voting stock. Thus, neither the number of voting shares nor the value of voting shares was determinative. Citing to regulations under Reg , the IRS ruled that voting power is measured based on the total number directors that the class of stock is entitled to elect as a class. 23 The 10 Percent Vote Requirement was again interpreted by the IRS in Rev. Rul. 85-3, which considered whether a taxpayer was entitled to a deemed-paid FTC on dividends paid by a foreign corporation where multiple members of a U.S. consolidated group owned, in the

10 aggregate, more than 10 percent of the voting stock. 24 The revenue ruling held that a deemed-paid FTC was not allowed since no domestic corporation independently owned the requisite 10-percent voting interest. The ruling reasoned that [g]enerally, when the income tax laws require a person to own a certain percentage of voting stock, they mean own in the ordinary, common sense understanding of the term; that is, actual or outright ownership. 25 The revenue ruling also states that [s]ection 902(a) does not contain any indirect ownership provisions that make indirect ownership a part of actual or direct ownership. 26 First Chicago The IRS s position in Rev. Rul was issued in advance of litigation involving nearly identical facts in the Tax Court case First Chicago Corp. 27 In First Chicago, multiple members of the taxpayer s U.S. consolidated group owned shares of a Dutch corporation. The First Chicago U.S. consolidated group owned more than 10 percent of the voting stock of the Dutch corporation in the aggregate, but at no time did any one group member own the requisite 10-percent vote. Despite arguments from First Chicago that the consolidated group rules should allow for ownership aggregation for purposes of Code Sec. 902, the Tax Court ruled in favor of the IRS. First Chicago appealed to the Seventh Circuit. On appeal, the Seventh Circuit ruled in favor of the IRS. 28 The court s opinion, written by Chief Judge Posner, agreed with the IRS that [t]he statute, read literally, does not permit aggregation. 29 The court granted the IRS interpretive deference in holding that ownership under Code Sec. 902 does not include indirect ownership through consolidated group members. 30 Interesting for purposes of our discussion herein, the court compared indirect ownership of foreign voting stock through a corporation with indirect ownership through a partnership and acknowledged that FTCs would have been allowed if the stock had been indirectly owned through a partnership. If one of the corporations making up the First Chicago family owned 5 percent of the Dutch bank s voting stock directly and 5 percent through a partnership, the holdings would be aggregated for purposes of section In light of this dicta, consider the example illustrated in Figure 2. [Place Figure 2 here]

11 2-260 Practising Law Institute In this case, deemed-paid FTCs with respect to dividends paid on the five-percent stock issued by Foreign Corp would be unavailable with respect to the structure on the left, but not on the structure on the right. While true in the example above, it is not always the case that there is a benefit to owning foreign-voting stock indirectly through a partnership for purposes of Code Sec For example, compare the two diagrams shown in Figure 3. [Place Figure 3 here] Here, the 10 Percent Vote Requirement would be met when a foreign corporation is owned through a corporate subsidiary but would not be met where that same foreign corporation is owned through a partnership. Although these examples appear arbitrary, as Judge Posner explained: it is difficult to attribute to Congress a desire to avoid the element of arbitrariness that First Chicago has stubbed its toes on; and arbitrariness is everywhere in the tax code, so that an approach to interpretation that sought to purge the arbitrary from the code would be quixotic. 32 CODE SEC. 902(c)(7) AND ITS HISTORY The only time the IRS has addressed the availability of a deemed-paid FTC with respect to stock owned by a partnership is in Rev. Rul In Rev. Rul , two domestic corporations formed a domestic general partnership. The domestic general partnership acquired a 40- percent interest in a foreign corporation. 33 The question addressed in the ruling was whether the corporations, as equal partners in the partnership, would be entitled to deemed-paid FTCs upon payment of dividends by the foreign corporation. The ruling concluded, with limited analysis, that because both partners were each a 50 percent owner of all the assets of the partnership, each partner was treated as owning 20 percent of the foreign corporation and met the 10 Percent Vote Requirement of Code Sec. 902(a). 34 Consequently, each partner was entitled to claim a deemedpaid FTC with respect to their distributive share of the dividends the partnership received from the foreign corporation. Rev. Rul provided guidance on at least two issues. First, it represented authority for the principle that a domestic corporate general partner may claim deemed-paid credits with regard to its distributive share of dividends received by the partnership from a foreign corporation. Second, it clarified that in order to determine whether a domestic corporate general partner is entitled to a deemed-paid FTC, a domestic 10

12 corporate partner is treated as actually owning the proportionate share of the assets of the partnership (including the stock of a foreign corporation) for purposes of determining whether a domestic corporate general partners met the 10 Percent Vote Requirement. Unfortunately, the revenue ruling did not provide guidance on how to determine a partner s proportionate share of the stock of a foreign corporation. In 1995, the IRS proposed that Reg (a)(1) be amended to provide that a domestic shareholder that is eligible for the Code Sec. 902 credit includes a domestic corporation that owns directly at least 10 percent of the voting stock of a foreign corporation at the time it receives a dividend. 35 In addition, the IRS requested comments on whether the holding of Rev. Rul should be expanded. 36 The notice of proposed rulemaking explained that: The [Service] is considering under what other circumstances a section 902 credit with respect to stock held by a partnership or other pass-through entity should flow through to a domestic corporation. The Service requests comments on whether the holding of Rev. Rul should be expanded to allow taxes paid by a foreign corporation to be considered deemed paid by domestic corporations that are partners in domestic limited partnerships or foreign partnerships, shareholders in limited liability companies, and beneficiaries of domestic or foreign trusts and estates or interest holders in other pass-through entities. 37 In response, the IRS received comments suggesting that the aggregate theory of partnerships should apply to allow domestic corporate partners to compute a deemed-paid credit on dividends paid to any partnership by a foreign corporation, provided that the partner owned at least 10 percent of the voting stock of the foreign corporation through the partnership. 38 In 1997, final regulations were issued under Code Sec In the preamble to the final regulations, the IRS explained that: The final regulations do not resolve under what circumstances a domestic corporate partner may compute an amount of foreign taxes deemed paid with respect to dividends received from a foreign corporation by a partnership or other pass-through entity. That issue will be the subject of a future proposed regulations project. However, in recognition of the holding in Revenue Ruling that a general partner of a domestic general partnership may compute an amount of foreign taxes deemed paid with respect to a dividend distribution from a foreign corporation to the partnership, (a)(1) is amended to define a domestic shareholder as a domestic corporation that owns the requisite voting stock in a foreign corporation rather than one that owns directly the voting stock. The IRS is still considering under what other circumstances the revenue ruling should apply. Thus, while the final regulations under Code Sec. 902 clarified that a taxpayer need not own directly the stock of a foreign corporation in order to meet the 10 Percent Vote Requirement, it did not expand the

13 application of Rev. Rul , which the IRS apparently believed only applied with respect to domestic general partnerships. As noted above, in 2004, Congress enacted Code Sec. 902(c)(7) in response to its belie[f] that a clarification [was] appropriate regarding the ability of a domestic corporation owning ten percent or more of the voting stock of a foreign corporation through a partnership to claim a deemed-paid foreign tax credit. 40 The House Report explained that prior to the enactment of Code Sec. 902(c)(7), the foreign tax credit provisions in the Code [did] not specifically address whether a domestic corporation owning ten percent or more of the voting stock of a foreign corporation through a partnership is entitled to a deemed-paid foreign tax credit. 41 Further, in its description of then-current law, the legislative history references Rev. Rul , the final regulations issued under Code Sec. 902 in 1997, and highlights the perceived uncertainty referenced in the preamble to the final regulations. 42 Thus, the legislative history provides that [section 902(c)(7)] clarifies that a domestic corporation is entitled to claim deemed-paid foreign tax credits with respect to a foreign corporation that is held indirectly through a foreign or domestic partnership, provided that the domestic corporation owns (indirectly through the partnership) ten percent or more of the foreign corporation s voting stock. 43 Unfortunately, although the statute refers to incidents of ownership that the IRS should consider in determining proportionate ownership, it does not give insight into how to determine a partner s proportionate interest in underlying partnership property for purposes of Code Sec PROPORTIONATE OWNERSHIP UNDER CODE SEC. 902(c)(7) The Code and regulations are replete with rules requiring that a partner be attributed a proportionate share of partnership assets, income or activities. 44 The term proportionate ownership is not defined in the Code. In the absence of a uniform definition, it follows that since proportionate share is a phrase used in different contexts in the Code and regulations, it should be given different meaning depending on the context in which it is used. 45 In the instant case, the purpose of Code Sec. 902(c)(7) is to allocate ownership of voting stock held by a partnership between partners based on their respective ownership in the partnership in order to determine whether the 10 Percent Vote Requirement is met. Thus, we must ask the following question: What should proportionate ownership mean in the context of Code Sec. 902(c)(7)? How does one determine how much of a partnership a partner should be treated as owning for purposes of meeting the Code Sec. 902 ownership rules?

14 To explore which approach would best suit Code Sec. 902(c)(7), the following incidents of ownership will be considered in this section: 1. The amount of voting power a partner has in the partnership 2. The Code Sec. 704(b) capital account of each partner at the time of dividend payment 3. The right each partner has to partnership profits (and in particular, to dividend income) 4. The right each partner has to the foreign-voting stock on liquidation of the partnership Voting Power In General Determining ownership of partnership-owned voting stock based on relative voting power is a compelling proposition, inasmuch as Code Sec. 902 is itself based on voting power. If Code Sec. 902 is based on ownership of voting power of a foreign corporation, doesn t it make sense to base proportionate ownership through a partnership on voting power in the partnership? In addition, in the international context, the degree of control an owner has in an entity is an important consideration. A primary example of this is the subpart F regime, 46 where measurement of voting power is required for the determination of whether a U.S. person is a U.S. shareholder, and measurements of either vote or value are necessary in determining whether a foreign corporation is a controlled foreign corporation. 47 Further, it is noteworthy that in Rev. Rul (discussed above), the IRS referenced regulations under subpart F to determine how the 10 Percent Vote Requirement should be applied where multiple classes of voting stock are outstanding. 48 Thus, there is precedent for the proposition that Code Sec. 902 should be applied by reference to regulations under subpart F. Code Sec. 958(a) and Indirect Ownership of Voting Power Code Sec. 958(a) provides that, for purposes of subpart F, a domestic corporation is treated as owning the stock of a foreign corporation that it indirectly holds through a foreign entity. For this purpose, foreign entity includes both a foreign corporation

15 and a foreign partnership. 49 Reg (c)(2) generally provides that a person s indirect ownership interest through a foreign entity is determined based on all the facts and circumstances. 50 The regulation explains that facts and circumstances include the purpose for which the rules of Code Sec. 958(a) are being applied. 51 Thus, when testing indirect ownership of the value of a lower-tier entity, the subpart F rules require taxpayers to look to the value held in the uppertier entity. Similarly, for voting power, the regulations provide that: if the rules of 958(a) are being applied to determine the amount of voting power owned in an indirectly held entity, for purposes of section 951(b) or 957, a person s proportionate interest in a foreign corporation will generally be determined with reference to the amount of voting power in such corporation owned by such person. 52 Thus, for purposes of determining a U.S. person s interest in the voting stock of a foreign corporation held through a foreign partnership, Code Sec. 958(a) looks to the U.S. person s voting power in the partnership. 53 Although the regulations under Code Sec. 958(a) provide an alluring option for applying Code Sec. 902(c)(7), especially given the reference to the subpart F rules in other guidance under Code Sec. 902, the regulations under Code Sec. 902 provide their own rules for calculating indirect ownership. In particular, indirect ownership under the Code Sec. 902 regulations is measured by multiplying the percentage ownership owned in a first-tier corporation by the ownership a first-tier corporation has in a second-tier corporation, and so on. 54 While the approach for calculating indirect ownership under the Code Sec. 902 regulations may yield the same result as if the Code Sec. 958(a) approach were applied, it may be difficult to argue that the Code Sec. 958(a) regulations should be instructive for applying Code Sec. 902(c)(7) when the Code Sec. 902 regulations provide a separate rule with the same purpose. Thus, the regulations under Code Sec. 902 appear to pose a potential regulatory limitation on applying Code Sec. 958 principles for determining indirect ownership in the context of Code Sec. 902(c)(7). How to Determine Voting Power? In addition to the potential regulatory limitation discussed above, applying Code Sec. 902(c)(7) based on voting power in the partnership would be a challenging endeavor. Sometimes the determination of voting power in a partnership is straightforward. In a general partnership, decision-making power may be split

16 based on relative capital contributed to the partnership, such that the person to whom indirect voting should be attributed may be easy to determine. Similarly, in the case of a foreign hybrid partnership (an entity taxed as a partnership for U.S. purposes but as a corporation under foreign law), voting power will likely be determined based on the amount of voting stock each partner is treated as owning under foreign law. The question can become more complicated in the case of limited partnerships, where a general partner is granted decisionmaking power under the relevant partnership agreement, but limited partners are granted power to remove the general partner with a majority or unanimous vote. In this case, is the general partner the only partner with vote? Does the limited partner hold all the voting power, with the general partner acting more like a board of directors in a corporation? In Figure 4, how should voting power be allocated if the General Partner can be removed but only with a unanimous vote of both the Majority Limited Partner and Minority Limited Partner? [Place Figure 4 here] Presumably, if the vote of both Minority Limited Partner and Majority Limited Partner is required to remove General Partner, Minority Limited Partner should be viewed as owning 50 percent of the voting power in PRS despite its relatively small economic interest. In addition, it might appear that the General Partner also has voting power because it is an owner who is exercising the rights that would normally be vested in a common shareholder. In such a case, one could conclude that the amount of voting power exceeds 100 percent. Alternatively, one could conclude that the General Partner has no voting power in PRS because it is merely acting as a fiduciary of the limited partners and is merely serving as a de facto board of directors. Unfortunately, there is no clear answer in this context, and given the dearth of authority, the IRS and Treasury might be forced to accede to either position if asserted by a taxpayer. 55 Code Sec. 704(b) Capital Accounts In General Partnerships typically maintain capital accounts for their partners. Capital accounts reflect a partner s economic interest in a

17 partnership, determined at the time of acquisition of a partnership interest, subject to certain adjustments. 56 Tracking capital accounts using Code Sec. 704(b) capital accounting rules serves as a safe harbor under the regulations that partnership allocations of income, gain, loss, deduction or credit have economic effect. 57 Partnership allocations that do not have economic effect are allocated based on a partner s interest in the partnership, which in turn refers to a facts-and-circumstances analysis that take into account transactions that would impact a partner s 704(b) capital. 58 Thus, the regulations under subchapter K regard Code Sec. 704(b) capital as a primary method for evaluating how much of a partnership a partner economically owns. Capital Accounts as a Proxy for Ownership Capital is often used as a proxy to determine whether an ownership threshold is met by a partner in a partnership under subchapter K. 59 This ownership convention can be found outside of subchapter K. For example, regulations under the FTC limitation rules of Code Sec. 904 also use capital as a proxy for determining a partner s proportionate value of a partnership (although, as is the case in much of subchapter K, the test is a conjunctive capital and profits test). 60 Under the Code Sec. 904 regulations, value based on capital and profits is determined at the end of the year. 61 If the policy for the 10 Percent Vote Requirement is to ensure that de minimis owners of corporate stock not be entitled to deemedpaid credits for administrative reasons, Code Sec. 704(b) capital accounts would provide an easily accessible calculation of how much of a partnership a partner owns. One potential issue with Code Sec. 704(b) capital accounting is that it may fail to capture the real-time economics of the partner s arrangement. 62 The real-time tracking of partner economics is a critical concern in the Code Sec. 902 context since the 10 Percent Vote Requirement requires that the 10-percent vote threshold be tested on the very day the foreign corporation pays a dividend. 63 Thus, to the extent dividends are paid at a time where the capital accounts do not coincide with the economics of an arrangement, an FTC might be disallowed when it should not be (or vice versa). An example of an instance where capital accounts do not track real-time economics is where capital accounts are not adjusted to reflect increases or decreases in the value of the underlying

18 partnership property. This mismatch is solved through a revaluation of partnership assets for capital account purposes, which is permitted but not required upon the occurrence of certain partnership events. 64 In the case of an introduction of a new partner, this may result in partners having a fielder s choice in determining whether a partner in a partnership has sufficient capital account ownership to credit deemed-paid FTCs. For example, assume Partner A and Partner B form PRS and each contribute $50. PRS purchases 100 percent of the stock of Foreign Corp. In Year 2, Foreign Corp appreciates by $120. In Year 3, Partner C contributes $20 to PRS to become a third partner. See Figure 5. [Place Figure 5 here] If PRS does not book up following the contribution by Partner C, the Code Sec. 704(b) capital accounts would be as shown in Table 1. [Place Table 1 here] Thus, if Foreign Corp pays a dividend in Year 3, since Partner C has an almost 17-percent interest in the capital accounts of PRS, it would be entitled to a deemed-paid credit. Alternatively, if PRS does book up following the contribution by Partner C, the Code Sec. 704(b) capital accounts would be as shown in Table 2. [Place Table 2 here] Because Partner C would only own just over eight percent of the PRS capital accounts in the case of a book-up, Partner C would not be entitled to any deemed-paid credits associated with dividends paid by Foreign Corp. Rights to Partnership Profits While capital accounts reflect the economic interest that a partner has in a partnership upon the acquisition of a partnership interest subject to adjustments, including increases for the amount of income allocated under Code Sec. 704(b), it does not necessarily track the type of income allocated to the partners. Thus, if the partnership agreement allows it, and subject to Code Sec. 704(b), partnerships are free to allocate profits from different types of property differently. The statutory language of Code Sec. 902(c)(7) suggests that Congress envisioned that the right to profits, and in particular special

19 allocations of those profits, be considered in determining proportionate interest. Code Sec. 902(c)(7) provides that [t]he Secretary may prescribe such regulations as may be necessary to carry out the purposes of this paragraph, including rules to account for special partnership allocations of dividends, credits, and other incidents of ownership of stock in determining proportionate ownership. (Emphasis added.) This raises at least a couple of questions. If Congress intended the right to profits to be an important factor in determining proportionate ownership, should taxpayers focus on the overall right to profits from the partnership or only on the right to profits with respect to foreign corporate voting stock (including special allocations thereof)? Did Congress intend for rights to profits to be an appropriate incident of ownership, ignoring special allocations of dividend income? The ability for partners to claim deemed-paid FTCs can vary depending on how these questions are answered. For example, assume PRS has two corporate partners: Partner A and Partner B. Partner A contributes $90 and Partner B contributes $10 to PRS, which uses the cash to start Business A and to purchase 50 percent of the voting stock of Foreign Corp. The PRS partnership agreement provides, in a manner that is in accordance with the regulations under Code Sec. 704(b), that Partner A and Partner B are entitled to 90 and 10 percent of all partnership income, respectively. See Figure 6. [Place Figure 6 here] First, let us assume that Code Sec. 902(c)(7) intended that rights to overall partnership profits be used to determine proportionate ownership. Partner A would be entitled to deemed-paid FTCs (50% voting stock 90% profits = 45% indirect voting stock ownership), but Partner B would not (50% voting stock x 10% profits = 5% indirect voting stock ownership). Thus, upon a dividend from Foreign Corp to PRS with an associated 20 of deemed-paid FTC, the partners would be entitled, in total, to 18 of deemed-paid FTCs (20 of FTCs Partner A s 90% profits interest). Alternatively, consider the same facts, but that Partner B will be specially allocated the dividends paid by Foreign Corp. See Figure 7. [Place Figure 7 here] In this case, one might argue that since Partner B is entitled to all of the dividend income from Foreign Corp, that it should be treated as owning all of the Foreign Corp stock held by PRS. Under this

20 approach, if Partner B is viewed as satisfying the 10 Percent Vote Requirement because it is allocated all partnership profit attributable to Foreign Corp, Partner B would be entitled to a deemed-paid FTC for the full 20. Perhaps this is the result with which Congress was concerned (or the result Congress intended) that a partner with a small share of partnership profits would be allowed to claim a deemed-paid FTC since it has rights to 100 percent of the dividend income from an indirectly held foreign corporation. Alternatively, one might argue that because A is not allocated any of the dividend income and, based on the allocation of partnership profits ignoring special allocations, B does not own a sufficient interest in Foreign Corp stock, the FTCs are permanently disallowed. Under this approach, one wonders what Congress would think of a special allocation of dividend income to Partner A. See Figure 8. [Place Figure 8 here] As discussed above, if rights to partnership profits (while ignoring special allocations) is the appropriate proxy for meeting the 10 Percent Voting Requirement, Partner A s entitlement to 90 percent of partnership profits in the example above would mean it meets the 10 Percent Vote Requirement. If the dividend income from Foreign Corp is specially allocated to Partner A, it would also be entitled to the full 20 of FTCs. It is noteworthy that in each alternative where there is a special allocation, there is an argument that the full 20 of FTCs should be creditable, whereas only 18 of FTCs would theoretically be permitted where there is no special allocation of dividend income. This begs the question of whether the right to profits is an appropriate measure of proportionate ownership under Code Sec. 902(c)(7). Rights to Property on Liquidation In General A partner s proportionate ownership in partnership property could also be determined based on their relative rights to partnership property on liquidation. Because an evaluation based on Code Sec. 704(b) capital accounts at a given point in time may yield seemingly incorrect results (see discussion above), it is arguably more precise to consider a partner s rights to liquidation value i.e., a partner s capital accounts as determined immediately before a hypothetical liquidation

21 A hallmark of the Code Sec. 704(b) substantial economic effect rules is that a partner s capital accounts should be adjusted for partnership income, loss, distributions and contributions, and that the partnership liquidates according to the adjusted capital accounts. 65 This ensures that partnership allocations have substantial economic effect. Where a partnership allocation does not have substantial economic effect, it must be allocated according to the partner s interest in the partnership (or PIP). 66 Similar to Code Sec. 704(b) capital accounting, PIP is determined in part by understanding a partner s economic right to partnership property on liquidation. 67 In the context of Code Sec. 704(b) capital accounts, the substantial economic effect regulations also require that, upon liquidation, the partnership book-up its capital accounts to take into account the revaluation of partnership property. 68 This requirement is significant in the Code Sec. 902 context. As discussed above, a significant flaw with using Code Sec. 704(b) capital accounts as a proxy for determining proportionate ownership is that the capital accounting rules do not always reflect real-time economics. Because liquidation rights are determined after taking into account all adjustments for the tax year, timing issues between Code Sec. 704(b) and Code Sec. 902 are avoided. Even if a partnership does not maintain capital accounts in accordance with the Code Sec. 704(b) regulations, each partner should be entitled to liquidations in accordance with the value of the partnership interest which is arguably equal to a booked-up capital account. One might argue that using rights on liquidation as an incident of ownership for determining a partner s proportionate interest of partnership property is difficult to administer and therefore impractical. Indeed, a partnership book-up is usually reserved for an extraordinary event, such as where the economic rights of the current partners are expected to shift. In order to properly book up capital accounts, valuations may be required. Requiring a partnership, especially one with many partners, to book up every time dividends are paid on foreign stock held by partnership may be viewed as frustrating the policy of the 10 Percent Vote Requirement (administrative convenience). However, this book-up approach is used elsewhere in the regulations. 69 The use of rights in liquidation would also appear consistent with Congress concern with administrability. In particular, where a partnership owned a less-than-10- percent portfolio interest in a foreign corporation, none of its

22 partners could achieve 10-percent ownership of total voting power (unless combined with direct ownership). AUTHORITIES SUPPORTING RIGHTS ON LIQUIDATION While none of the relevant authorities provide direct guidance on the appropriate incident of ownership that should be used for calculating indirect ownership, one can draw inferences from language used in Rev. Rul As discussed above, Rev. Rul ruled that the 10 Percent Vote Requirement was met because each partner was a 50 percent owner of all the assets of the partnership. 70 This suggests that a critical determination to the drafters of such ruling was not a partner s ownership or control of the partnership as an entity, but instead the degree to which a partner had rights in the partnership s underlying assets. Further, Congress enacted Code Sec. 902(c)(7) in order to provide clarification regarding the ability of a domestic corporation owning a foreign corporation through a partnership to claim a deemed-paid foreign tax credit. 71 In describing the law at the time of the enactment of Code Sec. 902(c)(7), Congress cited to Rev. Rul and commented that uncertainty remains regarding whether a domestic corporation owning a foreign corporation through a partnership is entitled to a deemed-paid foreign tax credit (other than through a domestic general partnership). 72 If Congress enacted Code Sec. 902(c)(7) to clarify uncertainty under Code Sec. 902, yet acknowledged that there was no uncertainty to the extent Rev. Rul applied, one might argue that Code Sec. 902(c)(7) has no impact on the conclusion in the Revenue Ruling. If true, this supports a read that a partner s right to partnership assets on liquidation is the key consideration. CONCLUSION The Code and regulations provide multiple instances where it is necessary to determine indirect ownership through a partnership. Sometimes the relevant rules indicate which incidents of ownership to use, and sometimes they do not. Unfortunately, the latter is true with respect to Code Sec. 902(c)(7). In the absence of administrative guidance, we have considered the legislative history of Code Sec. 902 and, in particular, the 10 Percent Vote Requirement; administrative and judicial authorities applying the 10 Percent Vote Requirement; guidance leading up to the enactment of Code Sec. 902(c)(7) and the legislative history of the provision itself

23 The policy behind the 10 Percent Vote Requirement is administrative convenience, which tells one very little when trying to understand how Code Sec. 902(c)(7) should be best applied. In addition, although in the international tax context it is typical to determine indirect vote ownership based on the voting power of the intermediary property, Code Sec. 902 has its own rules for determining indirect vote, so reliance on other rules in the code is dubious at best. In addition, the weight of authority tends toward looking beyond ownership in the entity itself and thus beyond voting stock ownership. If one were to agree that something closer to an attributive approach should apply, there are at least three different methods that can be applied. In such a case, one must ask which approach strikes the best balance of being practicable and getting to the right answer? * The authors would like to thank Mark Opper and Seth Goldstein for their invaluable insight throughout the process of developing this article. In addition, the authors would like to thank Meyer Jacobson for all the research that allowed us to bring this article to publication. This article contains general information only and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this article. Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (DTTL), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as Deloitte Global ) does not provide services to clients. Please see for a detailed description of DTTL and its member firms. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting. 1. Code Sec. 902(c)(7). (Emphasis added.)

24 2. Kristen A. Parillo, ABA Meeting: Guidance on Deemed Paid FTCs Must Wait, Says IRS Official, WORLDWIDE TAX DAILY, Feb. 2, Deemed-paid FTCs are also permitted with respect to income inclusions under Code Sec. 951(a) (i.e., subpart F income) under Code Sec See Reg (a)(9), which provides that: if an amount is distributed or deemed distributed by a foreign corporation to a United States person that is not a domestic shareholder within the meaning of paragraph (a)(1) of this section (for example, an individual or a corporation that owns less than 10% of the foreign corporation s voting stock)... then although no foreign income taxes shall be deemed paid under section 902, foreign income taxes attributable to the distribution or deemed distribution... shall be removed from [the post-1986 foreign income tax pool]. 5. Code Sec. 902(b). 6. Id. To the extent dividends are paid by foreign corporations that are owned by a domestic corporation in a fourth through sixth tier of ownership, the foreign corporation must also be a CFC and the taxes accrued by the foreign corporation must relate to periods during which the foreign corporation was a CFC. Reg (a)(4)(ii). Deemed-paid foreign taxes attributable to dividends paid by foreign corporations owned below a sixth tier are disallowed. Id. 7. See H.R. CONF. REP. NO , at 10, 15 (1919). 8. Code Sec. 222 (1919). 9. Code Sec. 238 (1919). 10. Code Sec. 240(c) (1919). 11. Id. 12. Elisabeth A. Owens and Gerald T. Ball, The Indirect Credit: A Study of Various Foreign Tax Credits Granted to Domestic Shareholders Under U.S. Income Tax Law, at 45 and n. 21 (INT L TAX PROGRAM, Law School of Harvard University, 1975). 13. Code Sec. 240(b) (1919). 14. Act Secs. 332(a) and 332(b) of the Revenue Act of 1951 (P.L. 183). 15. S. REP. NO , at (1951). 16. Id. 17. Owens and Ball, supra note 12, at See, e.g., Rev. Rul , CB 199; Rev. Rul , CB 237; Rev. Rul , CB 170; Rev. Rul , CB 181; Rev. Rul , CB 208 (obsoleted by Rev. Rul , IRB , 388); Rev. Rul , CB 207; Rev. Rul , CB Rev. Rul , CB Id. 21. Rev. Rul , CB Rev. Rul. 84-6, CB Id. 24. Rev. Rul. 85-3, CB Id., at Id. 27. First Chicago Corp., 96 TC 421, Dec. 47,218 (1991)

25 28. First Chicago NBD Corp., CA-7, 98-1 USTC 50,169, 135 F3d 457, aff g, 61 TCM 1774, Dec. 47,152(M), TC Memo ; see also Rev. Rul. 85-3, CB First Chicago NBD Corp., 135 F3d, at First Chicago NBD Corp., 135 F3d, at Id. First Chicago was decided before the enactment of Code Sec. 902(c)(7), the court s conclusion that indirect ownership through a partnership would be aggregated was presumably based on the IRS position set forth in Rev. Rul , discussed below. 32. Id. Interestingly, the court in First Chicago explained that the different result between ownership through a corporation and a partnership is justified because a partnership is not a separate taxable entity. But a corporation is. Thus, the court was of the view that, at least for purposes of Code Sec. 902, ownership should be aggregated through passthrough entities (including grantor trusts), but not through corporations, and that in determining ownership of a foreign corporation under the 10 Percent Vote Requirement, taxpayers must aggregate ownership through entities that are not separate taxable entities. This approach is consistent with Code Sec. 902(c)(7) and the administrative guidance leading up to its enactment, discussed below. 33. Rev. Rul , C.B Id. (Emphasis added.) 35. NPRM, CB Id. 37. Id. 38. T.D. 8708, CB Id. 40. See H.R. REP. NO , at 195 (2004); H.R. REP. NO , at 388 (2004); STAFF OF J. COMM. ON TAX N, 108TH CONG., GEN. EXPLANATION OF TAX LEGISLA- TION, at 275 (2005). 41. H.R. REP. NO , at Id. 43. Id. (Emphasis added.) 44. See e.g., Code Sec. 954(c)(3) and (4); Reg (a)-1T(c)(3)(ii); Reg (d)(3); Reg (h); Reg (a)(3); and Reg (a)(4). 45. See e.g., NPRM REG pp. 6-9, (Sept. 2, 2015) (where the IRS and Treasury evaluate various approaches for allocating partnership liabilities and assets to partners based on their proportionate ownership for purposes of Code Sec. 956). 46. The Code, Chapter 1, Subchapter N, Part III, Subpart F, being Code Secs Code Secs. 951(b); 957(a). 48. Rev. Rul. 84-6, CB 178. See infra pp Code Sec. 958(a)(2). 50. Reg (c)(2). 51. Id. 52. Id. 53. See Reg (d), Examples 1 and 2. Example 2 provides: United States person C is a 60-percent partner in foreign partnership X. Partnership X owns 40 percent of the one class of stock in foreign