Partnerships and the Proposed Debt-Equity Regulations

taxnotes Partnerships and the Proposed Debt-Equity Regulations By Charles Kaufman Reprinted from Tax Notes, September 26, 2016, p. 1843 Volume 152, Number 13 September 26, 2016

Partnerships and the Proposed Debt-Equity Regulations by Charles Kaufman Charles Kaufman is a senior manager in the passthroughs group of KPMG LLP s Washington National Tax practice. In this article, Kaufman examines the treatment of partnerships under the proposed section 385 regulations and explores the regulations application to funds and alternative investment vehicle structures. The information in this article is of a general nature and based on authorities that are subject to change. Its applicability to specific situations should be determined through consultation with your tax adviser. The article represents the views of the author only and does not necessarily represent the views or professional advice of KPMG. Treasury and the IRS recently released proposed regulations 1 under section 385 that, if finalized, would dramatically change the treatment of intercompany debt issued among the members of many corporate groups. The proposed regulations were issued as part of a broader package that includes temporary regulations addressing inversion transactions under sections 7874 and 367, as well as specific post-inversion tax planning transactions. Although the associated Treasury release describes the proposed regulations as designed to reduce the benefits of and limit the number of corporate tax inversions, including by addressing earnings stripping, the proposed regulations would likely have their greatest impact outside the inverted company context. 2 A. Overview of the Proposed Regulations The proposed regulations can be divided into four parts that very generally: give the IRS, but not taxpayers, the ability to bifurcate an instrument into part debt and part equity (prop. reg. section 1.385-1); TAX PRACTICE tax notes set forth documentation, timing, and maintenance requirements that must be satisfied for a related-party instrument to be characterized as debt for federal tax purposes (prop. reg. section 1.385-2); recast specific related-party debt instruments as stock for all federal tax purposes when issued (1) as a distribution; (2) in exchange for related-party stock; (3) as consideration (boot) in an internal asset reorganization; or (4) to fund a distribution, acquisition of related-party stock, or boot in an internal asset reorganization (prop. reg. section 1.385-3); and provide rules for application of the proposed regulations to U.S. consolidated groups (prop. reg. section 1.385-4). 1. Prop. reg. section 1.385-1 (bifurcation rule). The proposed regulations provide that the IRS can bifurcate a debt instrument issued between related parties that are members of the same modified expanded group (MEG) as part debt and part equity if, based on the facts and circumstances at the instrument s issuance, the instrument should be treated as part debt and part equity under general federal tax principles (the bifurcation rule). A MEG consists of: a group of corporations each member of which is linked by direct or indirect 3 ownership of at least 50 percent of the vote or value of its shares; partnerships in which at least 50 percent of the capital or profits interests is owned directly or indirectly by any members of the MEG; and individuals or entities that own or are treated as owning at least 50 percent of another member of the MEG. The bifurcation rule is much broader in application than the other sections of the proposed regulations (discussed below) because it (1) uses a 50 percent ownership threshold instead of an 80 percent threshold, (2) could apply to partnerships that are not owned by group members, and (3) could apply to individuals. 1 See REG-108060-15 (prop. reg. section 1.385-1 through -4). 2 Treasury release, Treasury Announces Additional Action to Curb Inversions, Address Earnings Stripping (Apr. 4, 2016). 3 For purposes of the proposed regulations, indirect stock ownership is determined by applying the rules of section 304(c)(3), which in turn reference the attribution rules of section 318. TAX NOTES, September 26, 2016 1843

COMMENTARY / TAX PRACTICE The proposed regulations illustrate the bifurcation rule with the following example. 4 Consider a $5 million debt instrument that is issued by a corporation to another modified group member. If the issuer cannot reasonably be expected to repay more than $3 million of the principal amount, the IRS may treat the instrument as $3 million of debt instrument and $2 million of stock. The bifurcation rule will be effective for debt instrument issued on or after the date the proposed regulations are finalized. 2. Prop. reg. section 1.385-2 (documentation rule). Prop. reg. section 1.385-2 requires members of an EG to prepare and maintain contemporaneous documentation for any instrument between group members (an expanded group instrument (EGI)) that is in form a debt obligation (the documentation rule). An EG consists of: a group of corporations each member of which is linked by the ownership, directly or indirectly, of at least 80 percent of the vote or value of its shares; and partnerships in which at least 80 percent of their capital or profits interests are owned directly or indirectly by one or more members of the EG. Failure to satisfy any element of the documentation rule will result in the EGI being treated as stock for federal income tax purposes. Satisfying the documentation requirements does not ensure debt treatment, however, and the IRS may still challenge characterization of an EGI on other grounds. The documentation rule has four requirements that must be satisfied (within specified periods): 1. written documentation establishing that the issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand on one or more fixed dates; 2. written documentation establishing that the holder has typical creditor rights (for example, a trigger or acceleration right upon nonpayment and the right to sue to enforce payment), which must include a liquidation right superior to shareholders; 3. written documentation establishing that as of the date of issuance and taking into account all the relevant circumstances, the issuer s financial position supported a reasonable expectation that it intended to and would be able to meet its obligations under the terms of the instrument; and 4 See preamble to REG-108060-15, 81 F.R. 20912, at 20919 (Section II.C). 4. evidence of a debtor-creditor relationship, such as written evidence of payments of principal or interest for example, a wire transfer or bank statement showing payments, and in the event of payment not in accordance with the EGI s terms or default, written documentation demonstrating the holder s reasonable exercise of the diligence and judgment of a creditor. The documentation that taxpayers prepare under the foregoing requirements is not automatically submitted to the IRS (such as filings that accompany the taxpayer s tax return each year). However, upon request by the IRS, the taxpayer must provide the documentation in a timely manner. There are exceptions to the documentation rule for some small, nonpublic EGs and for specific situations in which a failure to satisfy a requirement of the documentation rule is due to reasonable cause. The documentation rule will be effective for debt instruments issued on or after the date the proposed regulations are finalized. 3. Prop. reg. section 1.385-3 (automatic equity rule). Some debt instruments that satisfy the documentation requirements may still automatically be treated as equity under the proposed regulations (the automatic equity rule) if they are issued in any of the situations described below, subject to specific exceptions. The proposed regulations first provide a general rule under which the following debt instruments will automatically be treated as equity: debt issued by a corporation to an EG member in a distribution; debt issued by a corporation to an EG member in exchange for the stock of an EG member, for example, a section 304 sale (other than an issuance in an exempt exchange); or debt issued in exchange for property in an asset reorganization if the instrument is received, under the plan of reorganization, by a transferor corporation shareholder that is an EG member regarding its transferor corporation stock (for example, as boot in a reorganization under section 368(a)(1)(D)). The government apparently views those transactions as suspect because it perceives them as having limited nontax significance while creating the potential for significant tax benefits (such as interest deductions). The proposed regulations treat the above debt instruments as stock for all federal tax purposes. That recharacterization, as with recharacterization under the documentation rules, will not merely deny the associated interest deduction to the issuer but also trigger a wide-ranging series of collateral effects, the full scope of which is beyond the subject of this article. 1844 TAX NOTES, September 26, 2016

Also, to prevent taxpayers from circumventing the general rule by having a borrower EG member issue a debt instrument for property (such as cash) and then transfer the property to another EG member (including the lender), the proposed regulations provide a funding rule. Under that rule, a debt instrument will be treated as equity if it is issued for property (such as cash) to a member of the issuer s EG with a principal purpose of funding (1) a distribution of cash or other property by the funded member to a member of the EG, (2) an acquisition by the funded member of the stock of a member of the EG, or (3) the acquisition of property by the funded member in specific intragroup asset reorganizations. The principal purpose test is subject to a broad non-rebuttable presumption under which a debt instrument will be treated as stock if it is issued by the issuing corporation during a period beginning 36 months before and ending 36 months after any of the three types of transactions described in the preceding sentence. If a debt instrument is issued outside that window, it may still be treated as issued with a principal purpose of funding those transactions and thus be subject to the funding rule. That determination will be made on the basis of all the facts and circumstances. By effectively making the taxpayer s intent in issuing the debt instrument irrelevant for a six-year period, however, the funding rule as written would have a breathtakingly broad reach that cannot be overstated. The proposed regulations provide an important exception to the automatic equity rule under which distributions or acquisitions that do not exceed the current year s earnings and profits of the distributing (or acquiring) corporation are not treated as distributions (or acquisitions). For example, if an EG subsidiary has $100 of current-year E&P in year X, it may distribute a $100 debt instrument to its EG parent in year X, and that distribution will not trigger application of the automatic equity rule. The E&P exception may also arise with application of the funding rule. For example, if the EG parent lends the EG subsidiary $100 in year 1 and in year 2, the EG subsidiary has current-year E&P of $100. Under the E&P exception, if in year 2 the EG subsidiary distributes $100 to its parent, the distribution will not cause the $100 loan from the parent to the subsidiary to be treated as equity under the funding rule. The proposed regulations also provide a de minimis exception to the automatic equity rule under which debt instruments are treated as equity if the aggregate issue price of all the EG s debt instruments that would otherwise be treated as equity under the automatic equity rule does not exceed $50 COMMENTARY / TAX PRACTICE million. 5 This exception has a cliff effect, however, because if the EG s debt instruments that are subject to the automatic equity rule later exceed $50 million, the entire amount of the EG s debt instruments are treated as equity (including the first $50 million). The proposed regulations also include an ordinary course exception for debt issued in connection with the purchase of property or services if the payment obligation is currently deductible or capitalized and is comparable in amount and duration to similar arrangements between unrelated parties. There is no other generalized short-term or de minimis exception for the types of debt subject to the funding rule. The proposed regulations also contain a broad antiabuse rule under which a debt instrument may be treated as stock if it is issued with a principal purpose of avoiding the application of prop. reg. section 1.385-3 or -4. The antiabuse rule could apply, for example, if an EG member issues a debt instrument to a third-party bank and another EG member then acquires the debt instrument from the bank with a principal purpose of avoiding the application of prop. reg. section 1.385-3. Also, the antiabuse rule provides that an interest that is not a debt instrument for purposes of prop. reg. section 1.385-3 or -4 (for example, a contract to which section 483 applies or a nonperiodic swap payment) will be treated as stock if issued with a principal purpose of avoiding the application of prop. reg. section 1.385-3 or -4. That second application of the antiabuse rule may be particularly relevant for partnerships, as discussed below. The automatic equity rule will be effective for debt instruments issued on or after April 4, 2016 (or deemed issued before that date as a result of an entity classification election filed on or after April 4, 2016). Recognizing the burden of what is in essence a retroactive effective date, the proposed regulations provide a transition rule under which any debt instrument that would be treated as stock before the date the proposed regulations are finalized is treated as debt for 90 days after that date. On the 91st day, the debt instrument is deemed exchanged (in a tax-free exchange) for stock on the finalization date. Thus, taxpayers have 90 days from the date that the proposed regulations are finalized to transfer, dispose, or otherwise arrange their financial affairs regarding debt instruments implicated by that transition period for the automatic equity rule. 5 Debt issued before April 4, 2016, would not count for purposes of the $50 million threshold. TAX NOTES, September 26, 2016 1845

COMMENTARY / TAX PRACTICE 4. Prop. reg. section 1.385-4 (U.S. consolidated group rules). Prop. reg. section 1.385-4 provides that members of a U.S. consolidated group are treated as a single entity for purposes of the proposed regulations. Therefore, debt instruments issued by a member of a U.S. consolidated group to another member are generally not subject to the rules of the proposed regulations. B. Partnership Provisions Prop. reg. section 1.385-1, -2, and -3 each provide a different set of rules for the treatment of partnerships. Under prop. reg. section 1.385-1, a partnership will be a member of a MEG if at least 50 percent of the interests in partnership capital or profits are owned directly or indirectly by one or more members of a MEG. Also, if a partnership directly or indirectly owns at least 50 percent of the value of the stock of a MEG member, the partnership is treated as a member of the MEG. Thus, in contrast to the partnership rules in prop. reg. section 1.385-2 and -3, discussed below, a partnership may be subject to the bifurcation rule even if none of its partners are members of a MEG. Under prop. reg. section 1.385-2, a controlled partnership meaning a partnership in which at least 80 percent of the capital or profits interests are directly or indirectly owned by any EG members is treated as a member of the EG. Therefore, debt issued by a controlled partnership to an EG member is subject to the documentation rule. In that case, failure to meet the documentation rule requirements would result in the EG member (that is, the lender) owning an equity interest in the partnership. For example, suppose a controlled partnership is owned 50 percent by EG member A and 50 percent by EG member B. EG member C makes a loan of $100 to the controlled partnership and fails to document the loan in accordance with the documentation rule. Accordingly, the $100 loan is recharacterized as equity, resulting in C becoming a partner in the partnership, owning (in all likelihood) an interest in the partnership that entitles it to receive a guaranteed payment. 6 Moreover, interest payments on the loan by the partnership to C would likely be recharacterized as a guaranteed payment for C s partnership interest. 7 The recharacterization of partnership debt as equity under prop. reg. section 1.385-2 may give rise to other (unintended) consequences. For example, under section 752(b), any decrease in a partner s share of the liabilities of a partnership is treated as a distribution of money to the partner by the partnership. Therefore, when partnership debt is recharacterized as equity, presumably each partner would be treated as receiving a distribution in an amount equal to its share of that debt. To the extent the distribution exceeds a partner s basis in its partnership interest, the partner would have taxable gain. 8 Further, if a disregarded entity issues an EGI that is treated as equity (because of failure to comply with the documentation rule), prop. reg. section 1.385-2 treats the EGI as an equity interest in the disregarded entity rather than as stock in the disregarded entity s owner. Therefore, consider a disregarded entity owned by EG member A that borrows from EG member B and fails to comply with the requirements of the documentation rule. B would thus be treated as owning an equity interest in the disregarded entity, apparently causing that entity to convert into a partnership when the note is issued. This could lead to a multitude of issues, not the least of which is partnership filing obligations. Moreover, transactions between A and its former disregarded entity would now be subject to the disguised sales rules of section 707. Also, debt issued by the disregarded entity to A, which previously did not exist for federal tax purposes, would now spring to relevance as debt of the partnership, with potentially serious implications for A. Prop. reg. section 1.385-3 treats a controlled partnership (80 percent ownership by EG members of partnership capital or profits) as an aggregate of its partners (for partners that are EG members). Thus, each EG member that is a partner in a controlled partnership (for its EG) is treated as owning its proportionate share of the partnership s assets and issuing its proportionate share of any debt instrument issued by the partnership. For those purposes, a partner s proportionate share is determined in accordance with the partner s share of partnership profits. 9 1. Partnership as an issuer (borrower). If a debt instrument issued by a controlled partnership is 6 One may question whether it is appropriate to treat EG member C as a partner in the partnership if it is entitled solely to a guaranteed payment and no share of partnership profits. The proposed regulations do not address the status of parties that become equity holders in partnerships and disregarded entities as a result of debt recasts under the documentation rule. 7 It may make little or no difference to the partners in the controlled partnership whether payments by the partnership to (Footnote continued in next column.) EG member C are treated as interest payments or as a guaranteed payment; in either case, the partners would receive the benefit of a deduction for those payments. 8 Also, the recharacterization of partnership debt as equity can reduce partnership minimum gain, resulting in minimum gain chargebacks to partners. 9 The proposed regulations provide no guidance on how to determine a partner s share of partnership profits. For example, (Footnote continued on next page.) 1846 TAX NOTES, September 26, 2016

recharacterized as equity under the automatic equity rule, the holder of the recharacterized debt instrument is treated as holding stock in the EG partners of the controlled partnership, and the partnership and its partners must make appropriate conforming adjustments to reflect that treatment. Any such adjustments must be consistent with the purposes of prop. reg. section 1.385-3 and be made in a manner that avoids the creation of, or increase in, a disparity between the controlled partnership s aggregate basis in its assets and the aggregate bases of the partners respective interests in the partnership. For example, assume Partnership AB is owned by EG member A and EG member B and issues a $100 debt obligation to EG member C that is treated as equity under the automatic equity rule. A and B are each treated as issuing $50 of stock to C. This treatment alone generally creates an inside-outside basis discrepancy of $50 for A and B because they can no longer include the amount of the debt in their outside basis under section 752. To cure that discrepancy, the proposed regulations suggest that the following steps are deemed to occur 10 : A and B each issue stock to C for $50; and A and B then each contribute that $50 to the partnership in exchange for a partnership interest. That deemed contribution increases their respective bases by $50, restoring inside-outside basis parity. This approach should generally work well if each partner s debt share under section 752 equals its share of partnership profits. However, if that is not the case, the result is murky. To illustrate, in the above example, assume EG member A has a basis of $40 in its partnership interest as a result of the debt, EG member B has a basis of $60 in its partnership interest as a result of the debt, and partnership profits are shared 50-50. If the debt is recharacterized under the automatic equity rule, each partner is treated as issuing $50 of stock (in accordance with profit share) to EG member C. If each partner is then treated as contributing $50 to the partnership, each partner will have a $10 inside-outside basis discrepancy. This is because A s outside basis is reduced by $40 as a result of the debt recharacterization but then increased by $50, whereas B s basis is reduced by $60 as a result of the debt recharacterization and then increased by only $50. Another potential area of uncertainty is when a controlled partnership issues debt to an EG member COMMENTARY / TAX PRACTICE that is also a partner in the partnership. 11 For example, assume Partnership ABC is owned equally (for partnership profit-sharing purposes) by EG member A, EG member B, and EG member C, and it issues a $100 debt obligation to C that is treated as equity under the automatic equity rule. Applying the proposed regulations literally, C would be treated as acquiring $33 stock in A, $33 stock in B, and $33 stock in itself an odd result. Perhaps in that scenario, C s $33 proportionate share of the debt should not be recharacterized as equity. The proposed regulations offer no guidance on this question. Another area of uncertainty is the treatment of a controlled partnership s interest payments on debt issued by the partnership that is recharacterized as equity under the proposed regulations. For example, if Partnership AB issues a $100 debt obligation to EG member C that is treated as equity, what is the tax result when the partnership makes a $10 interest payment to C? Because the debt no longer exists, the payment cannot be treated as an interest payment. Moreover, under prop. reg. section 1.385-3, C does not own equity in the partnership but rather is treated as owning equity solely in EG member A and EG member B. Thus, the $10 interest payment by the partnership to C cannot be treated as a guaranteed payment. A seemingly plausible approach would be to deem the following steps to occur: Partnership AB distributes $10 to A and B ($5 to each), and then A and B make a corresponding total $10 distribution to C with respect to the equity owned by C in A and B. Under this approach, the $10 deemed distribution by the partnership to A and B would reduce their basis in their respective partnership interests (and potentially result in the recognition of gain and the need for the partnership to consider an election under section 754 to adjust basis under section 734). Another possible approach would be to treat the partnership as making a $10 guaranteed payment to A and B ($5 to each), and then A and B make a corresponding total $10 distribution to C with respect to the equity owned by C in A and B. Under this approach, A and B each have guaranteed payment income that is offset by their share of guaranteed payment deductions, resulting in no net gain or loss. It would be helpful if the final regulations offered guidance on the treatment of interest payments by the partnership in this scenario. if a partner is entitled to an 8 percent preferred return plus 30 percent of residual profits, it is unclear what its share of partnership profits would be. 10 See prop. reg. section 1.385-3(g)(3), Example 14. 11 Assume for these purposes that the debt instrument issued by the partnership to the partner would be respected as debt under general partnership tax law. TAX NOTES, September 26, 2016 1847

COMMENTARY / TAX PRACTICE If an EG member makes a loan to a controlled partnership, it would seem that in testing distributions for the purposes of the funding rule, one would test distributions made by the EG member partners and not distributions by the partnership itself. For example, when Partnership AB issues a $100 debt obligation to EG member C, if either EG member A or EG member B makes a distribution exceeding current-year E&P within three years to another EG member, a portion of the debt will be recharacterized as equity. However, distributions made by the partnership to its partners should arguably not trigger application of the funding rule, because the partnership itself is not the funded member (and not an EG member) for purpose of prop. reg. section 1.385-3. 12 Moreover, the proposed regulations provide an example illustrating the steps that are deemed to occur if a controlled partnership issues debt to an EG member that is respected as debt in the year of issuance but in a later year is recharacterized as equity as a result of the funding rule. 13 Consider controlled Partnership AB (owned by EG member A and EG member B) that in year 1 issues a $100 debt obligation for cash to EG member C that is respected as debt under the proposed regulations. In year 2, A and B each distribute $50 to C (assuming no exception applies), causing the debt instrument to be treated as $50 equity in A and $50 equity in B under the funding rule. The example provides that the following steps are deemed to occur in year 2: A and B each assume $50 liability for the debt instrument issued by the controlled partnership, so there is no longer debt at the partnership level and the outside basis of the partners is unchanged; and A and B issue $50 stock to C in satisfaction of the debt instrument. As previously discussed, the proposed regulations are silent on the treatment of future interest payments made by the controlled partnership on debt that no longer exists for federal tax purposes. Finally, the above rules could have significant consequences for S corporations. Consider Partnership AB that is owned by EG member A, an S corporation, and EG member B that issues a $100 debt obligation to EG member C that is treated as equity under the automatic equity rule. S corporations, although excluded from affiliatedconsolidated corporation status under section 1504, 12 One may question, however, whether the aggregate approach of prop. reg. section 1.385-3 should be applied to treat distributions by the partnership as partner-to-partner distributions. 13 See prop. reg. section 1.385-3(g)(3), Example 15. are not similarly excluded from (and thus can be) EG member corporation status. Accordingly, A and B are each treated as issuing $50 of stock to C. This could jeopardize A s status as an S corporation since it is now treated as having a corporate shareholder (C). Further, if the rights and benefits of C differ from other S corporation shareholders regarding the S corporation, A may be treated as having issued two classes of stock. The proposed regulations provide no guidance on the application of the proposed regulations to S corporations. 2. Partnership as a lender. If an EG member issues debt to a controlled partnership, under the aggregate approach mandated by prop. reg. section 1.385-3, each partner is treated as acquiring its proportionate share of the debt instrument. Therefore, if the debt instrument is recharacterized as equity under the automatic equity rule, each partner would be treated as owning its proportionate share of equity in the issuer (based on the partner s share of partnership profits). For example, assume EG member A and EG member B each own a 50 percent share of the profits of Partnership AB, and that EG member C, a subsidiary of AB, distributes a $100 debt instrument to AB that is recharacterized as equity under the automatic equity rule. Applying the rules, A and B would each be treated as acquiring a $50 equity interest in C. 14 In that case, when C then makes an interest payment of, say, $10 to Partnership AB, it would seem that the following steps would be deemed to occur. First, C makes a $5 distribution to A and B for their equity in C, and then A and B each contribute $5 to the partnership. Note that in this case the proposed regulations modify the pure aggregate approach of prop. reg. section 1.385-3 by providing that the debt instrument issued by C is treated as equity held by A and B (and not the partnership) solely for purposes of prop. reg. section 1.385-3. For all other federal tax purposes, the debt instrument issued by C is treated as equity held by the controlled partnership, and thus the distribution of the debt instrument by C to the controlled partnership is treated as a stock distribution to a shareholder in a distribution subject to section 305. 15 3. Additional open partnership issues. The preamble to the proposed regulations requests comments on several partnership-related issues, including: 14 One may question what the result would be if EG member C was itself a partner in the partnership. 15 See prop. reg. section 1.385-3(g)(3), Example 13. 1848 TAX NOTES, September 26, 2016

whether some indebtedness commonly used by investment partnerships, including indebtedness issued by specific blocker entities, implicates section 385 policy concerns such that the scope of the proposed regulations should be broadened; whether guidance is needed under section 909 to the extent a U.S. equity hybrid instrument arises solely by reason of the application of prop. reg. section 1.385-3; the treatment of controlled partnerships in prop. reg. section 1.385-3 and the treatment of collateral consequences of debt recharacterization and any corresponding adjustments, such as (1) the treatment of a partner s proportionate share of partnership assets or debt instruments, and (2) the treatment of a debt instrument that is deemed issued by a controlled partnership as stock in its EG partners, including when a recharacterization results in a partnership owning stock of an EG partner; and how to apply prop. reg. section 1.385-3 when EG partners make distributions subject to the funding rule for only some partnership debt instruments; when any but not all EG partners make a distribution subject to the funding rule for part or all of their share of the partnership debt instrument; and how to address those distributions when a controlled partnership has any partners that are not EG members. The preamble also notes that the IRS is concerned that controlled partnerships may issue equity interests to EG members instead of debt instruments to avoid the application of prop. reg. section 1.385-3. Holders of those equity interests could then receive either preferred returns or guaranteed payments. Thus, the partners could effectively achieve the equivalent of interest deductions through the allocation of income away from them to the preferred partner or through deductions arising from guaranteed payments. The preamble states that Treasury and IRS are considering rules that would treat preferred equity in a controlled partnership as equity in the EG partners. Until that guidance is issued, the IRS intends to closely scrutinize, and may challenge when the regulations become effective transactions in which a controlled partnership issues preferred equity to an EG member and, within the relevant 72-month period, any EG partners in the controlled partnership engage in the funding rule transactions described above. Note that the antiabuse rule could be read to apply to this scenario of a preferred equity interest issued by a controlled partnership. The antiabuse rule provides that an interest that is not a debt instrument for purposes of prop. reg. section 1.385-3 COMMENTARY / TAX PRACTICE or -4 (for example, a contract to which section 483 applies or a nonperiodic swap payment) will be treated as stock if issued with a principal purpose of avoiding the application of prop. reg. section 1.385-3 or -4. It is unclear how broadly to read the phrase an interest that is not a debt instrument, but presumably it can be read to include a preferred partnership interest. 16 If in fact it is applied in that scenario, the holder of a preferred partnership interest may be treated as a holder of stock in the other EG partners, and thus the other EG partners would not get the benefit of the allocation of income away from them to the preferred partner (or the deductions arising from guaranteed payments). C. Application to Funds and AIV Structures The good news for many funds is that to be subject to the proposed regulations, an EG which necessarily requires at least two corporations linked by the common ownership thresholds must exist somewhere in the structure. Because funds and management companies are typically organized as partnerships for tax purposes, application of the proposed regulations (particularly the automatic equity rule) to funds should therefore be somewhat limited. However, funds will need to engage in due diligence to determine the applicability of the proposed regulations to their structures because the rules may implicate some relatively common situations, such as the following: Bring your own blocker structure. If a corporate investor invests through its own blocker into a fund, the investor and the blocker may constitute an EG. Further, if the fund is owned 80 percent (directly or indirectly) by the blocker, it may be a controlled partnership. Thus, loans between (1) the corporate investor and the blocker and (2) the blocker and partnership could be subject to application of the proposed regulations. Parallel AIV-blocker fund structure. A sponsor may often set up parallel alternative investment vehicles (AIVs), each with its own blocker to block effectively connected income and unrelated business income tax for foreign investors or tax-exempt entities. Under the broad attribution rules of section 318, the blockers may be 80 percent related for purposes of the proposed regulations and thus constitute members of an EG. In that case, 16 In particular, the issuance of mandatorily redeemable preferred equity by a partnership could generate IRS scrutiny and risk under the antiabuse rule if issued to avoid application of the proposed regulations. TAX NOTES, September 26, 2016 1849

COMMENTARY / TAX PRACTICE partnerships that are owned 80 percent (directly or indirectly) by those blockers may be treated as controlled partnerships. Partnership sandwiched between two corporations. 17 If a corporate investor or blocker invests in a partnership that in turn invests in a portfolio company treated as a corporation, the corporation above the partnership and the portfolio company below the partnership may be members of an EG and subject to application of the proposed regulations. Brother-sister corporations owned by a partnership. If a fund owns a blocker and a portfolio company treated as a corporation for U.S. tax purposes, the brother-sister corporations may be members of an EG. Although the language of the proposed regulations may not yield that result, 18 the government has indicated that it will amend the language in the final regulations to make that result clear. Therefore, loans between these brother-sister corporations may be subject to application of the proposed regulations. 17 This structure has become increasingly common because portfolio company owners or service providers often seek to receive some form of partnership equity. 18 See prop. reg. section 1.385-1(b)(3)(B), substituting directly or indirectly for indirectly for purposes of section 1504(a)(1)(B)(i) but inexplicably omitting a reference to section 1504(a)(1)(B)(ii). Tax Notes welcomes submissions of commentary and analysis pieces on federal tax matters that may be of interest to the nation s tax policymakers, academics, and practitioners. To be considered for publication, REITs and TRSs. Because real estate investment trusts and their taxable subsidiaries are corporations for federal tax purposes, a REIT and its TRS would generally be treated as members of an EG. (As with S corporations, there is no exception to EG member status for REITs that similar to the section 1504(b) exclusion in the affiliated-consolidated group context.) Therefore, loans from a REIT to its TRS would generally be subject to application of the proposed regulations. S corporations that own a partnership interest. As discussed above, if an S corporation is a partner in a controlled partnership that issues debt to an EG member, the S corporation may be treated as issuing stock to that EG member. This could cause the S corporation to violate the restriction on having two classes of stock or a corporate shareholder. D. Conclusion SUBMISSIONS TO TAX NOTES The proposed regulations, if finalized in substantially similar form, would dramatically alter how taxpayers analyze debt in their organizational structures. Also, many issues regarding the treatment of partnerships under the proposed regulations remain open and require further guidance. As taxpayers conduct their tax planning and tax compliance, they will need to understand and consider the impact of the proposed regulations at all levels of their organizational structure. articles should be sent to the editor s attention at tax.notes@taxanalysts.org. Submission guidelines and FAQs are available at taxanalysts.com/submissions. 1850 TAX NOTES, September 26, 2016