American Bar Association Section of Taxation Section 2011 Midyear Meeting. Hot Topics in Partnerships January 21, 2011

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1 American Bar Association Section of Taxation Section 2011 Midyear Meeting January 21, 2011

2 Panelists Paul F. Kugler, KPMG LLP Dawn Duncan, Ernst & Young LLP Beverly Katz, Special Counsel to the Associate Chief Counsel (Passthroughs and Special Industries), IRS Page 2

3 Section 108(e)(8) Page 3

4 Section 108(e)(8) General Background Common law stock-for-debt exception was codified in Section 108(e)(8) as part of the Bankruptcy Tax Act of See Capento Securities Corp. v. Comm r, 140 F.2d 382 (1st Cir. 1944), aff g, 47 BTA 691 (1942), nonacq., 1943 C.B. 28. Through successive amendments to Section 108(e)(8) in 1984, 1986 and 1990, Congress narrowed the application of the exception by (among other things) limiting its availability to debtors in title 11 cases and insolvent debtors. The stock-for-debt exception was repealed though amendments to Section 108(e)(8) as part of the Omnibus Budget Reconciliation Act of Although the 1993 Act repealed the stock-for-debt exception, the existence of a partnership equity-for-debt exception remained an open question. Page 4

5 Section 108(e)(8) General Background Section 108(e)(8) was further amended as part of the American Jobs Creation Act of 2004 to clarify that an equity-for-debt exception does not exist in the partnership context. As amended by the 2004 Act, Section 108(e)(8) provides that, if a debtor partnership transfers a capital or profits interest in such partnership to a creditor in satisfaction of its recourse or nonrecourse indebtedness, such partnership shall be treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the capital or profits interest. On October 30, 2008, the IRS issued proposed regulations (REG ) relating to the application of Section 108(e)(8) to partnerships and their partners. Page 5

6 Section 108(e)(8) 2008 Proposed Regulations For purposes of determining income of a debtor from discharge of indebtedness, if a debtor partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of its recourse or nonrecourse indebtedness, the partnership is treated as having satisfied the indebtedness with an amount of money equal to the fair market value ( FMV ) of the partnership interest. Prop. Treas. Reg (a). To the extent the debt exceeds the FMV of the transferred partnership interest, the partners must include such amount in their distributive shares immediately before discharge as cancellation of debt ( COD ) income. The regulations generally create a "safe harbor" that allows the parties in a debt-forequity exchange to value the debt-for-equity interest based on a "liquidation value" approach. For purposes of this safe harbor, liquidation value is defined to mean the amount of cash that the creditor would receive with respect to the debt-for-equity interest if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) for cash equal to the FMV of those assets and then liquidated. Prop. Treas. Reg (b)(1). Page 6

7 Section 108(e)(8) 2008 Proposed Regulations The value of the debt-for-equity interest can only be determined based on liquidation value if the following requirements are satisfied: 1. The debtor partnership determines and maintains the capital accounts of its partners in accordance with the capital accounting rules of Section (b)(2)(iv); 2. The creditor, debtor partnership and its partners treat the FMV of the indebtedness as being equal to the liquidation value of the debt-for-equity interest for purposes of determining the tax consequences of the debt-forequity exchange; 3. The debt-for-equity exchange is an arm's-length transaction; and 4. After the debt-for-equity exchange, there is neither a redemption by the partnership nor a purchase by any person related to the partnership of the debt-for-equity interest as part of a plan which, at the time of the debt-for-equity exchange, has as a principal purpose the avoidance of COD income by the partnership. Prop. Treas. Reg (b)(1). If those four requirements are not satisfied, the FMV of the debt-for-equity interest must be determined based on all the facts and circumstances. Prop. Reg (b)(2). Page 7

8 Section 108(e)(8) Proposed Regulations 2008 Proposed Regulations The IRS also proposes to amend the Section 721 regulations to provide that Section 721 principles will apply on the partner side, so that no loss will be recognized by the creditor with respect to the debt. Prop. Reg (d)(1). Consistent therewith, the basis of the creditor s interest in the partnership will be determined under Section 722. As a result of these changes under Sections 108 and 721, non-recognition principles will not apply to preclude the recognition of COD income, yet nonrecognition principles will apply to preclude the recognition of loss with respect to the debt. Under this regime, the creditors loss will be embedded in its partnership interest and recognized upon the ultimate disposition of such interest. The character of any such loss on disposition of the partnership interest will likely be capital in nature under Section 741, as opposed to ordinary under Section 166. The creditor is arguably impaired from both a character and a timing perspective. Page 8

9 Section 108(e)(8) Current Issues 1. Allocation of COD income under the Section 704(b) rules Whether special rules are needed to allocate COD income to the remaining partners when an existing partner who is also a lender exchanges debt for equity under Section 108(e)(8) Whether COD income should be treated as a first-tier item under the minimum gain chargeback rules of Reg (f)(6). 2. Under the proposed regulations, a lender who becomes a partner in the exchange would not be entitled to a bad debt deduction. Should a bifurcation approach (i.e., ability to separately account for a creditor s built-in loss in connection with a debt-for-equity exchange) be used to avoid (i) asymmetry in the timing of the inclusion of COD income and the allowance of the creditor s loss, and (ii) the divergence between inside and outside tax basis that results from the debt-forequity exchange? Does statutory authority exist with respect to an approach that would deem a debt instrument to be bifurcated in connection with a transaction that otherwise would be considered an exchange under Section 721? Expand a creditor s opportunity to deduct a non-economic loss when receiving a profits interest that is valued at its liquidation value? Page 9

10 Section 108(e)(8) Current Issues 3. Section 721 does not apply to the transfer of a partnership interest to a creditor in satisfaction of a partnership's recourse or nonrecourse indebtedness for unpaid rent, royalties, or interest on indebtedness (including accrued original issue discount). Prop. Reg (d)(2). Limit this exclusion to interest and OID that accrued since the commencement of the creditor s holding period for the debt? Treat purchased claims for unpaid rent or royalties in a manner similar to any other debt obligation and, therefore, applying Section 721 to the exchanges of such claims for partnership equity? Requirement that equity issued in a debt-for-equity exchange to be allocated first to accrued and unpaid interest or OID before being allocated to principal. See Reg (e). Should the normal ordering rules apply? Under certain circumstances (e.g., the issuance of a profits interest in satisfaction of a claim for unpaid rent held by an accrual method lessor (or the purchaser of such a claim)), the use of liquidation value may allow the holder a current tax loss that exceeds the holder s economic loss. Even where Section 721 is rendered inapplicable to the creditor s exchange of debt for equity (i.e., where the debt claim is for unpaid interest, OID, rent or royalties), is the partnership required to recognize gain or loss as if it sold an undivided interest in each of its assets? Page 10

11 New Section 909 and Partnerships Page 11

12 New Section 909 Rules to prevent "splitting" of FTCs from foreign income Overview of Section 909 On August 10, 2010, the President signed into law the Education Jobs and Medicaid Assistance Act of 2010 (P.L. No ) Provides funding for state Medicaid reimbursement and education jobs programs Paid for with significant international tax changes that have immediate implications for companies global tax positions Section 211 of the Education Jobs and Medicaid Assistance Act of 2010 referred to as the Education Jobs and Medicaid Assistance Act of 2010, added Section 909 to the Code. Foreign Tax Splitting Event In the case of a foreign tax credit splitting event, foreign income taxes paid or accrued are suspended until the taxpayer takes the related foreign income into account. In the case of a foreign tax credit splitting event with respect to a Section 902 corporation, the tax is not added to the corporation s foreign tax pool, and its E&P is not reduced by such tax, before the taxable year in which the related income is taken into account by the Section 902 corporation, or a domestic corporation that meets the ownership requirements of Section 902(a) or (b) with respect to the Section 902 corporation. Page 12

13 New Section 909 Rules to prevent "splitting" of FTCs from foreign income Overview of Section 909 A foreign tax credit splitting event occurs with respect to a foreign income tax if the related income (or earnings, as appropriate ) is (or will be) taken into account by a covered person. Related Income - With respect to any portion of any foreign income tax, the income (or, as appropriate, E&P), calculated under US tax principles, to which such portion of foreign income tax relates. Covered Person - any entity in which the payor of the foreign income tax holds, directly or indirectly, at least a 10% ownership interest (determined by vote or value) any person that holds, directly or indirectly, at least a 10% ownership interest (determined by vote or value) in the payor of the foreign income tax any person that bears a relationship to the payor of the foreign income tax described in Section 267(b) or 707(b) (including by application of the constructive ownership rules of Section 267(c)) any other person specified by the Secretary Page 13

14 New Section 909 Rules to prevent "splitting" of FTCs from foreign income Overview of Section 909 Treatment of foreign taxes after suspension For purposes of determining the carryover of excess FTCs, the deduction for foreign taxes, and the extended period for refund claims, suspended foreign income taxes will be treated as paid or accrued in the year in which the related foreign income is taken into account (except as otherwise provided by the Secretary) Foreign taxes are translated into US dollars in the year in which the taxes are actually paid or accrued In case of a partnership, rules for suspension of taxes are applied at the partner level Except as otherwise provided by the Secretary, a similar rule will apply in the case of an S corp or trust Page 14

15 New Section 909 Rules to prevent "splitting" of FTCs from foreign income Overview of Section 909 Grant of regulatory authority for guidance necessary or appropriate to carry out the purposes of the provision including: Appropriate exceptions from the rules Proper application to hybrid instruments (see example in Joint Committee on Taxation (JCT) Explanation) JCT Explanation refers to expectation of regulations addressing: Treatment of losses, E&P deficits and timing differences Expansion of definition of covered person in abusive cases Successor rules Disregarded payments, group relief or other arrangements having similar effect Page 15

16 New Section 909 Rules to prevent "splitting" of FTCs from foreign income Effective date Provision applies to foreign income taxes paid or accrued in taxable years beginning after December 31, Provision also applies to foreign income taxes that are paid or accrued by a Section 902 corporation in taxable years beginning on or before such date and that are not deemed paid under Sections 902(a) or 960 on or before such date, but only for purposes of applying Sections 902 and 960 with respect to periods after 31 December Taxes suspended under this prong of the effective date do not trigger E&P adjustment upon either suspension or release. Page 16

17 New Section 909 Rules to prevent "splitting" of FTCs from foreign income Notice On December 6, 2010, the IRS published Notice , providing guidance on the application of new Section 909. Clarification of Effective Date - Section 909 does not apply in computing foreign taxes under Sections 902 or 960 before the first day of the Section 902 corporation's post-2010 tax year. Allows Section 902 corporations with tax years beginning on or before December 31, 2010, until the end of their 2010 fiscal tax year to pay dividends or "match" income with pre-2011 split taxes in order to prevent the application of Section 909. Pre-2011 Splitter Arrangements- Identifies an exclusive list of arrangements that will be treated as giving rise to foreign tax credit splitting events in pre-2011 tax years. The list includes: (i) Reverse hybrids; (ii) Foreign consolidated groups; (iii) Group relief and other loss sharing arrangements (but only in a very narrow set of circumstances); and (iv) Hybrid instruments. The Notice identifies the following pre-2011 taxes as taxes that are NOT suspended: (i) Pre-2011 split taxes paid or accrued by a Section 902 corporation before January 1, 1997; (ii) Pre-2011 split taxes deemed paid under Sections 902 or 960 on or before the last day of the Section 902 corporation's last pre-2011 tax year; (iii) Taxes not paid in connection with a pre-2011 splitter arrangement; and (iv) Pre-2011 split taxes for which the related income has been taken into account by the Section 902 corporation or a shareholder of such Section 902 corporation. Page 17

18 New Section 909 Rules to prevent "splitting" of FTCs from foreign income Notice The Notice provides that foreign taxes paid or accrued by a partnership are treated as pre-2011 split taxes to the extent such taxes (1) are allocated to one or more Section 902 corporations, and (2) would be pre-2011 split taxes if the partner had paid or accrued the taxes directly on the date the taxes are included by the partner under Sections 702 and 706(a). Any taxes subject to Section 909 are suspended at the partner-level Section 902 corporation. For purposes of applying Section 909 to a post-2010 year, foreign taxes paid or accrued by a partner with respect to its distributive share of the related income of the partnership are not treated as a foreign tax credit splitting event under Section 909 to the extent the related income is taken into account by the partner. Page 18

19 New Section 909 Rules to prevent "splitting" of FTCs from foreign income Notice The Notice indicates that certain allocations of creditable foreign tax expenditures ("CFTE") and partnership income, even if those allocations satisfy the requirements of Section 704(b), can result in a separation of CFTE and the related income for purposes of Section 909. The IRS plans to issue guidance indicating that the allocations described in Reg (b)(4)(viii)(d)(3) will result in a splitting event in post-2010 tax years to the extent that the partner allocated foreign taxes is not also allocated the related income. The Treasury and IRS solicited comments on the extent to which Reg (b)(4)(viii)(d) and (b)(5), Example 24 should be modified in light of the enactment of Section 909. The Notice indicates that partnership allocations that satisfy the requirements of Section 704(b) and the regulations thereunder will not constitute pre-2011 splitter arrangements except to the extent the arrangement meets the definition of one of the four splitter arrangements described in the Notice (for example, a payment or accrual on a disregarded debt instrument that gives rise to a shared loss). Page 19

20 New Section 909 and Section 704(b) CFTE Regulations (Example 24) USP Foreign Net Income DE1 DE2 Total Pre-tax Income Inter-branch Payment (75) 75 - US 1 US 2 Net Income Taxes DE1 (75%); DE2 (50%) Foreign PS DE1 (25%); DE2 (50%) Effective Tax Rate 40% 20% 23% U.S. Net Income DE1 DE2 Total Net Income DE1 (German) $75 (Interest) DE2 (Swiss) Taxes Pretax Income (75) Interest Payment 25 Net Income 10 (Tax) at 40% 50 Pretax Income 75 Interest Payment 125 Net Income 25 (Tax) at 20% Effective Tax Rate 10% 50% 23% Page 20

21 New Section 909 and Section 704(b) CFTE Regulations (Example 24) (paragraph (ii)) US 1 DE1 (75%); DE2 (50%) DE1 (German) 100 Net Income 10 (Tax) at 40% USP Foreign PS $75 (Interest) US 2 DE1 (25%); DE2 (50%) DE2 (Swiss) 50 Net Income 25 (Tax) at 20% Example 24 (paragraph (ii)) US1 US2 DE1 Net Income DE2 Net Income DE1 Taxes DE2 Taxes Effective Tax Rate 20% 30% Because $10 of German taxes are allocated in the same proportion as the distributive share of income to which the taxes relate and the $25 of Swiss taxes are allocated in the same proportion as the distributive share of income to which the taxes relate, the allocation of taxes are deemed to be in accordance with the partners interest in the partnership. Page 21

22 New Section 909 and Section 704(b) CFTE Regulations (Example 24) (paragraph (iii)) USP The partnership agreement provides that the $15 of Swiss tax imposed on the inter-branch payment is allocated 75% to US1 ($11.25) and 25% to US2 ($3.75) and the remaining $10 of Swiss tax is allocated 50% to US1 ($5) and 50% to US2 ($5). US 1 US 2 Example 24 (paragraph (iii)) US1 US2 DE1 Net Income DE2 Net Income DE1 (75%); DE2 (50%) Foreign PS DE1 (25%); DE2 (50%) DE1 Taxes DE2 Taxes % Sharing of DE2 Taxes 65% 35% Effective Tax Rate 24% 23% DE1 (German) 100 Net Income 10 (Tax) at 40% $75 (Interest) DE2 (Swiss) 50 Net Income 25 (Tax) at 20% The allocation with respect to the $15 of Swiss taxes paid by DE2 has the effect of tracing the foreign taxes to the corresponding income determined under U.S. tax principles. Upon sufficient substantiation that $15 of Swiss taxes paid by DE2 with respect to the $75 inter-branch payment relates to income recognized by DE1 for U.S. tax purposes, the allocation of the $10 of Swiss taxes are deemed to be in accordance with the partners interest in the partnership. Page 22

23 New Section 909 and Section 704(b) CFTE Regulations (Example 24) (paragraph (iv)) USP In order to reflect the $75 payment from DE1 to DE2, the partnership agreement allocates $75 of the income attributable to DE2 50% to US1 and 50% to US2. US 1 US 2 Example 24 (paragraph (iv)) US1 US2 DE1 Net Income DE2 Net Income DE1 (75%); DE2 (50%) Foreign PS DE1 (25%); DE2 (50%) DE1 Taxes DE2 Taxes % Sharing of DE1 Income 56.3% 43.8% Effective Tax Rate 25% 22% DE1 (German) 100 Net Income 10 (Tax) at 40% $75 (Interest) DE2 (Swiss) 50 Net Income 25 (Tax) at 20% 15 (Tax on Interest) The allocation with respect to the $75 of income of DE1 has the same effect as if the interest payment from DE1 to DE2 were respected for U.S. tax purposes in calculating the net income of DE1 and DE2. Upon sufficient documentation that all of the $10 of German taxes paid by DE1 relates to the $25 of DE1 s income that is shared in the same 75/25 ratio, the allocations of the German tax may be established to be in accordance with the partners interest in the partnership. Page 23

24 Proposed Series LLC and Cell Company Regulations Page 24

25 Proposed Series LLC Regulations General Background General Background First introduced in Delaware in 1996, statutes have been enacted by a number of states providing for the creation of entities, such as LLCs, that may establish series (often referred to as series LLC statutes ). In addition, certain jurisdictions have enacted statutes providing for entities similar to a series LLC (e.g., certain statutes provide for the chartering of a legal entity (or the establishment of cells) under a structure commonly known as a protected cell company, segregated account company, or segregated portfolio company ( cell company )). Proposed Regulations On September 14th, 2010, Treasury and the Service issued proposed regulations (REG ) that would treat, for federal tax purposes, a series of a domestic series LLC, a cell of a domestic cell company, and a foreign series or cell that conducts an insurance business as entities formed under local law, regardless of whether the entity is treated as a juridical person for local law purposes. Effective Date - Subject to a generous transition rule, these proposed regulations would generally become effective when they are published as final regulations in the Federal Register. Page 25

26 Proposed Series LLC Regulations General Policy - In the preamble to the proposed regulations, the Service and Treasury note their general agreement with the recommendation that series and cells should be treated as separate entities for federal tax purposes if formed under a statute with provisions similar to those governing the series LLC in effect in several states. Domestic Series - Under the proposed regulations, a series organized or established under the laws of the United States or of any state, whether or not a juridical person for local law purposes, would be treated as an entity formed under local law. Foreign Series - Additionally, a series organized or established under the laws of a foreign jurisdiction would be treated as an entity formed under local law if the arrangements and other activities of the series, if conducted by a domestic company, would result in classification as an insurance company under Sections 816(a) or 831(c). Page 26

27 Proposed Series LLC Regulations General Background Determination Under General Tax Principles - The determination of whether a series that is treated as a local law entity under the proposed regulations is recognized as a separate entity for federal tax purposes would be made under Reg and general tax principles. Potential classifications of a series include disregarded entity, partnership, and corporation (an entity that qualifies as an insurance company under Sections 816(a) or 831(c) would be a per se corporation). Entity Status and Filing Requirements - The proposed regulations do not address the entity status or filing requirements of series organizations for federal tax purposes. Series Organization As a Separate Entity - In addition, comments are requested concerning whether a series organization should be recognized as a separate entity for federal tax purposes if it has no assets and engaged in no activities independent of its series. Employment Tax Considerations - Notably, the proposed regulations do not provide how a series should be treated for federal employment tax purposes. Page 27

28 Proposed Series LLC Regulations General Background Definitions Series Organization - A series organization is defined as a juridical entity that establishes and maintains, or under which is established and maintained, a series. A series organization includes a series limited liability company, series partnership, series trust, protected cell company, segregated cell company, segregated portfolio company, or segregated account company. Series Statute - A series statute is defined as a statute of a state or foreign jurisdiction that explicitly provides for the organization or establishment of a series of a juridical person and explicitly permits: 1. Members or participants of a series organization to have rights, powers, or duties with respect to the series; 2. A series to have separate rights, powers, or duties with respect to specified property or obligations; and 3. The segregation of assets and liabilities such that none of the debts and liabilities of the series organization (other than liabilities to the state or foreign jurisdiction related to the organization or operation of the series organization, such as franchise fees or administrative costs) or of any other series of the series organization are enforceable against the assets of a particular series of the series organization. Page 28

29 Proposed Series LLC Regulations General Background Definitions Series - A segregated group of assets and liabilities that is established pursuant to a series statute by agreement of a series organization. A series includes a series, cell, segregated account, or segregated portfolio, including a cell, segregated account, or segregated portfolio that is formed under the insurance code of a jurisdiction or is engaged in an insurance business. An election, agreement, or other arrangement that permits debts and liabilities of other series or the series organization to be enforceable against the assets of a particular series, or a failure to comply with the record keeping requirements for the limitation on liability available under the relevant series statute, will be disregarded for purposes of the definition of a series. The proposed regulations would clarify that, except as specified in the proposed regulations, a particular series does not need to possess all of the attributes that its enabling statute permits it to possess. The proposed regulations would also clarify that until further guidance is issued, the entity status of a foreign series that does not conduct an insurance business is determined under applicable law. The proposed regulations provide that the Commissioner may, under applicable law, characterize a series or portion of a series as other than a separate entity (i.e., disregard a series under applicable law if it has no business purpose other than tax avoidance). Page 29

30 Proposed Series LLC Regulations General Background Transition Rule - The proposed regulations include an exception for a series established prior to publication of the proposed regulations that treats all series and the series organization as one entity. If the requirements for this exception are satisfied, the series may continue to be treated together with the series organization as one entity for federal tax purposes after issuance of the final regulations. This exception would cease to apply on the date any person or persons who were not owners of the series organization (or series) prior to the date of publication of the proposed regulations in the Federal Register own, in the aggregate, a 50% or greater interest in the series organization (or series). For this purpose, the term "interest" means (i) in the case of a partnership, a capital or profits interest and (ii) in the case of a corporation, an equity interest measured by vote or value. Page 30

31 Proposed Series LLC Regulations General Background Transition Rule The requirements for the transition rule exception would be satisfied if: 1.The series was established prior to the date of publication of the proposed regulations in the Federal Register; 2.The series (independent of the series organization or other series of the series organization) conducted business or investment activity or, in the case of a foreign series, more than half the business of the series was the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies, on and prior to the date of publication of the proposed regulations in the Federal Register; 3.If the series was established pursuant to a foreign statute, the series' classification was relevant (as defined in Reg (d)), and more than half the business of the series was the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies for all tax years beginning with the tax year that includes the date of publication of the proposed regulations in the Federal Register; 4.No owner of the series treats the series as an entity separate from any other series of the series organization or from the series organization for purposes of filing any federal income tax returns, information returns, or withholding documents for any tax year; 5.The series and series organization had a reasonable basis (within the meaning of Section 6662) for their claimed classification; and 6.Neither the series nor any owner of the series nor the series organization was notified in writing on or before the date final regulations are published in the Federal Register that classification of the series was under examination (in which case the series' classification will be determined in the examination). Page 31

32 Proposed Series LLC Regulations Selected Issues and Questions The preamble to the proposed regulations notes that insurance-specific guidance may still be needed to address the issues identified in Notice and for issues that may arise for protected cell companies that previously reported in a manner inconsistent with the regulations. Some of these issues the proposed regulations do not address are: How are protected cell companies treated? How are foreign cells that do not qualify as insurance companies treated? What are the tax implications when a cell is treated as a separate corporation in one year when it qualifies as an insurance company but not a separate corporation in a following year when it does not qualify as an insurance company? Is the change in status a taxable or taxexempt transaction? How will the tax attributes of the cell be treated as a result of the change in status? Will the participant in a cell be required to report information to the cell company in order to determine the status of the cell? How will an equity interest in a cell that qualifies as a separate corporation be treated as preferred stock or common stock? Page 32

33 Securities Aggregation Rule for Securities Partnerships Page 33

34 Securities Aggregation Rule General Background Property-by-Property Requirement - Section 704 (c) allocations are generally made on a property-by-property basis. Therefore, built-in gains and losses from different items of contributed or revalued property generally cannot be aggregated. Reg (a)(2). Special Rule for Securities Partnerships - Reg (e)(3) provides a special rule that allows securities partnerships to make reverse Section 704(c) allocations on an aggregate basis. Permits certain partnerships to aggregate gains and losses from an expanded class of qualified financial assets ( QFAs ) for purposes of making reverse Section 704(c) allocations under Reg (e)(3). For purposes of making reverse Section 704 (c) allocations, a securities partnership may aggregate built-in gains and losses from qualified financial assets using any reasonable approach that is consistent with the purpose of Section 704(c). Reg (e)(3)(i). Therefore, a securities partnership using an aggregate approach generally must account for any BIG or BIL from contributed property separately. Underlying Policy - According to the preamble to the final regulations, securities partnerships were afforded this flexibility because Treasury and the IRS recognized that "[t]he frequency of capital account restatements under section (b)(2)(iv)(f) and the number of partnership assets may make it unduly burdensome for certain securities partnerships to make reverse section 704(c) allocations on an asset-by-asset basis." The partnership must apply the same aggregate approach to all of its QFAs for all taxable years in which the partnership qualifies as a securities partnership. Page 34

35 Securities Aggregation Rule - General Background Aggregation of Forward Section 704(c) and Reverse Section 704(c) Amounts - In the preamble to the Section 704(c) final regulations, Treasury and IRS explained that the regulations do not authorize aggregation of BIG and BIL from contributed property with BIG and BIL from revaluations because this type of aggregation can lead to substantial distortions in the character and timing of income and loss recognized by contributing partners. Treasury and the IRS recognized, however, that there may be instances in which the likelihood of character and timing distortions is minimal and the burden of making Section 704(c) allocations with respect to contributed property (forward Section 704(c) allocations) separately from reverse Section 704(c) allocations is great. Therefore, the regulations authorize the IRS to permit, by published guidance or letter ruling, aggregation of QFAs for purposes of making forward Section 704(c) allocations. Reg (e)(4)(iii). Rev. Proc the IRS granted automatic permission for certain securities partnerships in master-feeder structures to aggregate contributed property for purposes of making Section 704(c) allocations. Under current law, master-feeder securities partnerships that satisfy the requirements of Rev. Proc are the only partnerships that are automatically allowed to aggregate forward and reverse Section 704(c) gains and losses. Private Rulings - PLR (Dec. 7, 2001), PLR , , (June 7, 1999), PLR (Dec. 1, 1998), , , (Feb. 13, 1998), , (Sept. 14, 1998), and (July 9, 1997). Page 35

36 Securities Aggregation Rule General Background Securities Partnership A partnership is a securities partnership if the partnership is either a management company or an investment partnership, and the partnership makes all of its book allocations in proportion to the partners' relative book capital accounts (except for reasonable special allocations to a partner that provides management services or investment advisory services to the partnership). Reg (e)(3)(iii)(A). Management Company A partnership is a management company if it is registered with the Securities and Exchange Commission as a management company under the Investment Company Act of 1940, as amended (15 U.S.C. 80a). Reg (e)(3)(iii)(B)(1). Investment Partnership A partnership is an investment partnership if (1) on the date of each capital account restatement, the partnership holds qualified financial assets that constitute at least 90 percent of the fair market value of the partnership's non-cash assets; and (2) the partnership reasonably expects, as of the end of the first taxable year in which the partnership adopts an aggregate approach under Reg (e) (3), to make revaluations at least annually. Reg (e)(3)(iii)(B)(2). Qualified Financial Asset - Any personal property (including stock) that is actively traded. Reg (e)(3)(ii)(A). For management companies, qualified financial assets also include the following, even if not actively traded: (i) shares of stock in a corporation; (ii) notes, bonds, debentures, or other evidences of indebtedness; (iii) interest rate, currency, or equity notional principal contracts; (iv) evidences of an interest in, or derivative financial instruments in, any security, currency, or commodity, including any option, forward or futures contract, or short position; or any similar financial instrument. Reg (e)(3)(ii)(B). Actively Traded - Actively traded as defined in Reg (d) - 1 (defining actively traded property for purposes of the straddle rules). Page 36

37 Securities Aggregation Rule General Background Aggregation Methods - Two methods of making reverse Section 704(c) allocations on an aggregate basis are described that are generally reasonable, the partial netting and the full netting approaches, respectively. Reg (e)(3)(iv) and (v). Other approaches, however, may be reasonable in appropriate circumstances. Reg (e)(3)(i). Both partial netting and full netting involve setting up, for each partner, a "revaluation account" that keeps track of book allocations that have not been matched with tax allocations. Partial Netting - Under the partial netting approach, tax gains and losses are netted separately. Gains (losses) are first allocated to partners with positive (negative) accounts in proportion to positive (negative) balances, and any excess is allocated pro rata to all partners. Full Netting - The full netting approach nets all tax gains and losses, and then allocates the net according to the same rule. Other Requirements - The character and other tax attributes of gains or losses allocated to the partners under an aggregate approach must: (i) preserve the tax attributes of each item of gain or loss realized by the partnership; (ii) be determined under an approach that is consistently applied; and (iii) not be determined with a view to reducing substantially the present value of the partners' aggregate tax liability. Reg (e)(3)(vi); See also Reg (a)(10). Transition Rule - Special transition rules are provided for partnerships that become subject to, or become disqualified from access to, the aggregation rules, and the Service has the power to extend the aggregation rules to other partnerships with other types of property. See Reg (e)(4). Page 37

38 Securities Aggregation Rule Rev. Proc Rev. Proc The Treasury and IRS issued Rev. Proc providing more flexible rules for qualifying partnerships to aggregate reverse Section 704(c) gain or loss from QFAs. A partnership is a qualifying partnership if it satisfies six requirements. 1. The partnership's book allocations satisfy the pro rata rule (i.e., the partnership makes "all of its Section 704(b) allocations" in proportion to the partners' relative Section 704(b) capital accounts (except for reasonable special allocations to a partner that provides management services or investment advisory services to the partnership). 2. The partnership reasonably expects, as of the end of the first taxable year in which the partnership adopts an aggregate approach under the revenue procedure, to make revaluations of QFAs at least four times annually. 3. On the date of each capital account restatement during the taxable year, the partnership satisfies the 90 percent test (i.e., the partnership holds QFAs that constitute at least 90 percent of the partnership's non-cash assets). 4. The partnership reasonably expects, as of the first day of each taxable year for which the partnership seeks to aggregate under the revenue procedure, that the partnership (a) will have at least ten unrelated partners (within the meaning of Sections 267(b) or 707(b)) at all times during the taxable year, and (b) will make at least 200 trades of QFAs during the taxable year, the aggregate value of which will comprise at least 50 percent of the book value of the partnership's assets (including cash) as of the first day of the taxable year. 5. The application of the aggregation method to reverse Section 704(c) allocations under the revenue procedure is not made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability. Page 38

39 Securities Aggregation Rule Benefits of Rev. Proc Allows all qualifying partnerships (i.e., both management companies and investment partnerships ) to use the more expansive definition of QFAs that, under the regulations, is available only to management companies 2. Treats certain lower-tier partnership interests as QFAs Specifically, a lower-tier partnership interest is a QFA if the interest (i) is traded on an established securities market or readily tradable on a secondary market or the substantial equivalent thereof within the meaning of Reg (c); or (ii) is an interest in a partnership that represents it is a securities partnership or a qualified partnership, provided that the upper-tier partnership does not actively or materially participate in the management or operations of the lower-tier partnership, and such interest is (A) less than ten percent of the capital and profits of the lower-tier partnership and (B) less than five percent of the total book value of the upper-tier partnership's assets (including cash) as of the first day of the taxable year. 3. Allows a qualified partnership to use a layering approach to account for some, but not all, of the partnership s QFAs A qualifying partnership may choose not to aggregate some of the partnership's QFAs, provided that those assets do not exceed in the aggregate 30 percent of the book value of the partnership's non-cash assets at the time any such assets are acquired. Page 39

40 Securities Aggregation Rule General Issues and Considerations 1. Many partnerships are unable to satisfy the 90 percent test Should the Section 704(c) regulations be modified to expand the class of partnerships that are eligible to use an aggregation method? Include any partnership for which separately accounting for revaluation gains and losses from QFAs is unduly burdensome? 2. A securities partnership may be prohibited from revaluing its assets under generally accepted industry accounting practices if it fails to satisfy the substantially all requirement (i.e., substantially all of the partnership's property (excluding money) consists of stock, securities, commodities, options, warrants, futures, or similar instruments that are readily tradable on an established securities market) Permit securities partnerships that use an aggregation method for QFAs to revalue at least annually in accordance with generally accepted industry accounting practices? The regulations do not define the term substantially all. Under generally accepted accounting principles, investment companies must use mark-to-market accounting. 3. Coordination and Compliance with Section 704(c)(1)(C) If a partnership is allowed to use an aggregation method to account for BIG or BIL in contributed property under Rev. Rul , do the Section 704(c) amounts need to separately track losses in order to comply with Section 704(c)(1)(C)? Page 40