Treasury Tightens Rules on Transfers to Partnerships with Related Foreign Partners
Notice 2015-54, issued on August 6, 2015, describes regulations that the Treasury and IRS will issue under section 721(c), section 482 and section 6662 addressing certain transfers of property, in practice principally intellectual property, to partnerships with related foreign partners that the Treasury and the IRS view unfavorably. The regulations will complement and coordinate with tighter cost sharing regulations issued in 2011.
The regulations to be issued under section 721(c) are effective for transfers occurring on or after August 6, 2015 and for entity classification elections (i.e., elections to on an entity be treated as a partnership) that are filed on or after August 6, 2015 and that are effective on or before August 6, 2015. The other regulations will be prospective, applying to transfers or controlled transactions occurring on or after the date of publication of the regulations.
Taxation of partnerships and partners
Partnerships are transparent entities for U.S. federal income tax purposes. The partners in a partnership report their distributive share of income, gain, loss and deductions of the partnership for its taxable year on their tax returns annually. Subject to various limitations in the partnership regulations, partnerships allow the flexible allocation of items of income and deductions among the partners to satisfy business goals.
Generally, a person transferring property to a partnership in exchange for a partnership interest does not recognize gain or loss on the transfer. The partner’s basis in its partnership interest is equal to the partner’s basis in the contributed property. Each year a partner’s tax basis in its partnership interest is increased by its share of income and capital contributions and reduced by its share of loses and distributions. Specials rules apply to determine the effect of liabilities of the partnership on a partner’s basis in its partnership interest.
When a partner contributes appreciated property (i.e., high-value, low-basis property) to a partnership, such contributed property creates a disparity between the “book” or fair market value of a partner’s partnership interest and its lower tax basis. The rules of section 704(c) apply to ensure that the contributing partner is taxed on the property’s pre-contribution gain, i.e., such gain is not allocated to other partners who may be taxed more favorably on such built-in gain. This is particularly as issue with built-in gain property that is a depreciating asset as it may not be sold for its value on the date of contribution.
Regulations issued under section 704(c) require the partnership to use a reasonable method to eliminate the book-tax disparity. Three methods are provided: the “traditional method,” the traditional method with “curative allocations,” and the “remedial method.” Under the current regulations, taxpayers may choose which method to apply, subject to certain limitations.
The traditional method requires the contributing partner to be allocated gain recognized on the sale of the appreciated property that it contributed. In addition, if the appreciated property is subject to amortization or depreciation, then deductions attributable to the property are allocated to the partnership’s noncontributing partners in an amount equal to those partners' share of book depreciation of the asset. It may be the case that a partnership does not produce sufficient deductions for tax purposes to totally eliminate the book-tax disparity created by the built-in gain property. This situation is known as the “ceiling rule.” Finally, any depreciation deductions that are not allocated to the other partners are allocated to the partner who contributed the built-in gain property. If the property is disposed of, any remaining built-in gain or loss allocable to the contributing partner is the difference between the tax and book bases for the property on the date of disposition. Thus, under the traditional method, a partner contributing appreciated property is allocated more taxable income than it otherwise would if the traditional method were not applied.
One approach provided in the regulations to address the ceiling rule is the remedial method. Under the remedial method, the traditional method is followed until the ceiling rule applies. The partnership then creates a remedial item of deduction to allocate to the noncontributing partners and an offsetting remedial item of income to allocate to the contributing partner. The total amount equals the amount of the excess of the book value of the asset over the asset’s tax basis. Such remedial items are wholly fictional, but they must have the same character as the item limited by the ceiling rule.
Taxation of transfers of intellectual property
Due to the relatively high U.S. corporate tax rate, U.S. multinationals have engaged in a variety of strategies to cause intellectual property to be owned outside the United States. With proper planning, the U.S. tax on the income generated by this property can be deferred until the income is repatriated to the U.S. parent. Deferral is desirable when the foreign tax on such income is less than the U.S. tax.
Generally, an outright transfer of intangible property to a foreign subsidiary is unattractive from a tax perspective because, under section 367(d), the transfer is recast as a sale for a contingent payment over a number of years and the payment may be subject to adjustment by the IRS based on hindsight. For many years, a more popular strategy was to enter into a cost sharing arrangement to allow the cost of developing new intellectual property to be shared between a U.S. member of the group and a foreign member with the foreign member owning the non-U.S rights to the developed property. In 2011, the IRS issued revised cost sharing regulations intended to make such arrangements less attractive to taxpayers. U.S. companies then increasingly turned to a partnership between a U.S. member of the group and a foreign member as an avenue to deferring U.S. tax on income from intellectual property. The flexibility of such arrangements allowed appreciation in the value of such property to accrue for the benefit of the foreign partner and permitted deferral of the U.S. tax on the built-in gain on the contributed property.
Section 721(c) and section 367(d)(3) give the Treasury regulatory authority to address transfers of property to partnerships with foreign partners. The provisions were added to the Code in 1997, but regulations were not issued. The IRS been working on revisions to the regulations under section 367(d) for quite some time. No project under section 721(c) was ever announced, however, so the notice was unexpected.
Regulations to be issued under section 721(c)
The notice states that the IRS is concerned with transactions in which a U.S. taxpayer contributes appreciated property to a partnership with related foreign partners that are not subject to U.S. tax and those foreign partners are improperly allocated income or gain from the contributed property. Taxpayers, according to the notice, also are using valuation techniques that are inconsistent with the arm’s-length standard.
Although there is authority in section 367(d)(3) to address transfers of intangibles to partnerships, the Treasury Department and the IRS decided to issue regulations under 721(c) “because the transactions at issue are not limited to transfers of intangible property.” The IRS also may have taken this approach because of the relatively narrow definition of intangible property in the Code and regulations under section 367(d). The Obama administration has sought legislation to expand the definition of intangible property; however, Congress and the administration have been unable to agree to tax legislation due to longstanding differences.
The regulations to be issued will apply when property (other than cash, securities and tangible property with a de minimis amount of built-in gain) defined in the notice as “Section 721(c) Property is transferred to a partnership if, after the transaction, a related foreign person is a “Direct or Indirect Partner” in the partnership and the U.S. person transferring the property and one or more related persons own more than 50 percent of the interest in the partnership capital, profits, deductions or losses. Such a partnership is known as a “Section 721(c) Partnership.”
The regulations will provide that when Section 721(c) Property is transferred to a Section 721(c) Partnership, the U.S. transfer must recognize gain on the transfer unless the “Gain Deferral Method” is applied by the partnership. The Gain Deferral Method requires that (i) the partnership adopt the remedial method with respect to the Section 721(c) Property, (ii) for any taxable year during which there is remaining built-in gain with respect to Section 721(c) Property the partnership must allocate all items of income, gain, loss and deduction with respect to that property in the same proportion, (iii) certain reporting requirements are satisfied, (iv) the U.S. transferor recognizes built-in gain with respect to any item of Section 721(c) Property upon the occurrence of an “Acceleration Event,”  and (v) the Gain Deferral Method is adopted for all subsequent contributions of Section 721(c) Property until the earlier of (a) the date that no built-in gain remains with respect to any Section 721(c) Property or (b) 60 months after the date of the initial contribution of Section 721(c) Property to which the Gain Deferral Method applied.
Regulations to be issued under section 482
The notice also announces that, on a prospective basis, the IRS will issue regulations under section 482 to address transfer pricing issues raised by the transfer of Section 721(c) Property to a Section 721(c) Partnership. These regulations will extend the specified methods in the cost-sharing regulations, e.g., the income method, to such transactions. (The preamble to the final cost-sharing regulations had limited the use of such methods to transactions involving cost-sharing arrangements.) The regulations also will provide a “commensurate with income” rule intended to allow upward adjustments of income allocated to the contributing partner when the contributed intangible is more profitable than expected at the time of contribution. This rule will be similar to the periodic adjustment rule found in the cost-sharing regulations.
Application of current law to Section 721(c) Partnerships and Section 721(c) Property
The final section of the notice describes how the IRS will apply existing law to the aforementioned transactions. These measures include:
- Applying section 482 to make adjustments to partnership allocations, including allocations under section 704(c).
- Utilizing one of the specified methods in the cost-sharing regulations as an “unspecified method” that is the most reliable measure of an arm’s-length result.
- Applying an aggregate analysis when affiliates contribute property or services to the Section 721(c) Partnership.
- Making a periodic adjustment based on Reg. § 1.482-4(f)(2) with respect to a section 936(h)(3)(B) intangible contributed to a partnership.
The regulations described in the notice are a clever regulatory solution, at least in part, to an issue that the Obama administration has not been able to address by legislation because of a poor working relationship with the Congress, i.e., expanding the scope of section 367(d) which currently has a narrow definition of intangible property.
The recourse to section 721(c) is not without its issues, however. Section 721(c) provides for the recognition of gain on the transfer property to a partnership “if such gain, when recognized, will be includible in the gross income of a person other than a United States person.” It is not clear that all contributions of the Section 721(c) Property to a Section 721(c) Partnership necessarily result in built-in gain being included in the income of a foreign person when recognized.
For example, one can imagine circumstances where the traditional method or curative allocations can avoid the problem that section 721(c) addresses. In those cases, the notice would appear to be overly broad and the regulations seem susceptible to challenge in the courts. In such cases, the regulations also may be subject to challenge as violating the nondiscrimination provision of a U.S. income tax treaty. The government therefore may ultimately find that a more nuanced approach than the Gain Deferral Method is appropriate to address its concerns.
 Section 704(c)(1)(A) provides: “income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution.” For example, consider the case of a partnership owning a single depreciable asset with a tax basis that is less than it’s built in gain. That subsection provides: “The Secretary may provide by regulations that the rules of paragraph (2) also apply to the transfer of intangible property by a United States person to a partnership in circumstances consistent with the purposes of this subsection.” A partner who owns an interest in a partnership directly, or indirectly through another partnership. An “Acceleration Event” is a transaction that would either reduce or defer the amount of built-in gain that a U.S. transfer or would recognize under the Gain Deferral Method. Also, an Acceleration Event is deemed to occur for any taxable year in which the partnership fails to comply with all the requirements of the Gain Deferral Method. The regulations also will provide rules to govern the transfer of a partnership interest to a domestic Corporation and transfers of Section 721(c) Property by partnership to a corporation in a section 351 transaction. Regulations to be issued prospectively and one additional requirement to the Gain Deferral Method. Taxpayers will be required to agree to extend the limitation period for the assessment of tax on all items related to Section 721(c) Property through the close of the taxable year following the taxable year of the contribution.
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