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Regs to be issued on U.S. person’s transfers of property to partnership with foreign partners

Notice 2015-54, 2015-34 IRB

In a Notice, IRS has announced that it intends to issue regs under Code Sec. 721(c) to ensure that, when a U.S. person transfers certain property to a partnership that has foreign partners related to the transferor, income or gain attributable to the property will be taken into account by the transferor either immediately or periodically.IRS also intends to issue regs under Code Sec. 482 and Code Sec. 6662 applicable to controlled transactions involving partnerships to ensure the appropriate valuation of such transactions.

Background.Code Sec. 721(a) provides a general rule that no gain or loss is recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.Because Code Sec. 367 only applies to the transfer of property to a foreign corporation, absent regs under Code Sec. 721(c) or Code Sec. 367(d)(3), a U.S. person generally doesn’t recognize gain on the contribution of appreciated property to a partnership with foreign partners.

Code Sec. 482 provides, in part, that IRS may make allocations between or among two or more organizations, trades, or businesses (whether or not incorporated or affiliated and whether or not organized in the U.S.) that are owned or controlled directly or indirectly by the same interests in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses.Reg. § 1.482-1(a)(2) provides that IRS may make allocations between or among the members of a controlled group if a controlled taxpayer hasn’t reported its true taxable income.In such a case, IRS may allocate income, deductions, credits, allowances, basis, or any other item or element affecting taxable income.Reg. § 1.482-1(b)(1) provides that, in determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.

Code Sec. 6664(c) provides generally that a penalty may not be asserted under Code Sec. 6662 with respect to a portion of an underpayment if it is shown that there was reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.However, when IRS determines that a penalty otherwise would apply as the result of a net Code Sec. 482 transfer price adjustment, or as the result of a gross valuation misstatement, Code Sec. 6662(e)(3)(D) provides that, for purposes of Code Sec. 6664(c), the taxpayer isn’t treated as having reasonable cause unless additional requirements are met.

Reason for IRS’s concern.IRS is aware that certain taxpayers purport to be able to contribute, consistently with Code Sec. 704(b), Code Sec. 704(c), and Code Sec. 482, property to a partnership that allocates the income or gain from the contributed property to related foreign partners that are not subject to U.S. tax.Many of these taxpayers choose a Code Sec. 704(c) method other than the remedial method and/or use valuation techniques that are inconsistent with the arm’s length standard.

Code Sec. 721(c) regs to be issued.In Notice 2015-54, IRS said it intends to issue regs that will provide that Code Sec. 721(a) will not apply when a U.S. person, other than a domestic partnership, (i.e., a U.S. Transferor) contributes an item of Section 721(c) Property (or part of such) to a Section 721(c) Partnership, unless the Gain Deferral Method is applied with respect to that property.(Notice 2015-54, Sec. 4.02)

Section 721(c) Property is defined as property, other than Excluded Property, with Built-in Gain.Excluded Property, in turn, is defined as (1) cash equivalents, (2) any asset that is a security under Code Sec. 475(c)(2) (without regard to Code Sec. 475(c)(4)), and (3) any item of tangible property with Built-in Gain that doesn’t exceed $20,000.With respect to an item of property contributed to a partnership, Built-in Gain is the excess Code Sec. 704(b) book value of the property over the contributing partner’s adjusted tax basis in the property at the time of the contribution (and doesn’t include gain created when a partnership revalues partnership property).(Notice 2015-54, Sec. 4.01)

A partnership (domestic or foreign) is a Section 721(c) Partnership if a U.S. Transferor contributes Section 721(c) Property to the partnership, and, after the contribution (and any transactions related to the contribution):

a. a person that is related within the meaning of Code Sec. 267(b) or Code Sec. 707(b)(1)) to a U.S. Transferor (i.e., a Related Person), other than a partnership, that is not a U.S. person (i.e., a Related Foreign Person) is a person (other than a partnership) that owns an interest in a partnership directly or indirectly through one or more partnerships (i.e., is a Direct or Indirect Partner), and
b. (b) the U.S. Transferor and one or more Related Persons own more than 50% of the interests in partnership capital, profits, deductions or losses. (Notice 2015-54, Sec. 4.01)

The regs will include a de minimis rule providing that section 721(a) (if otherwise applicable) will continue to apply (without regard to whether the requirements of the Gain Deferral Method are satisfied) if during the U.S. Transferor’s taxable year (1) the sum of the Built-In Gain with respect to all Section 721(c) Property contributed in that year to the Section 721(c) Partnership by the U.S. Transferor and all other U.S. Transferors that are Related Persons does not exceed $1 million, and (2) the Section 721(c) Partnership is not applying the Gain Deferral Method with respect to a prior contribution of Section 721(c) Property by the U.S. Transferor or another U.S. Transferor that is a Related Person.(Notice 2015-54, Sec. 4.02)

Gain Deferral Method.The requirements for applying this method are:

1. The Section 721(c) Partnership adopts the remedial allocation method in Reg. § 1.704-3(d) for Built-in Gain for all Section 721(c) Property contributed to the Section 721(c) Partnership pursuant to the same plan by a U.S. Transferor and all other U.S. Transferors that are Related Persons;
2. During any tax year in which there is remaining Built-In Gain with respect to an item of Section 721(c) Property, the Section 721(c) Partnership allocates all items of Code Sec. 704(b) income, gain, loss, and deduction with respect to that Section 721(c) Property in the same proportion. For example, if income with respect to an item of Section 721(c) Property is allocated 60% to the U.S Transferor and 40% to a Related Foreign Person in a tax year, then gain, deduction, and loss with respect to that Section 721(c) Property must also be allocated 60% to the U.S. Transferor and 40% to the Related Foreign Person;
3. The reporting requirements described in Notice 2015-54, Sec. 4.06, are satisfied;
4. The U.S. Transferor recognizes Built-in Gain for any item of Section 721(c) property upon an Acceleration Event—any transaction that either would reduce the amount of remaining Built-in Gain that a U.S. Transferor would recognize under the Gain Deferral Method if the transaction hadn’t occurred or could defer the recognition of the Built-in Gain. An Acceleration Event is deemed to occur with respect to all Section 721(c) Property of a Section 721(c) Partnership for the tax year of the Section 721(c) Partnership in which any party fails to comply with all of the requirements for applying the Gain Deferral Method; and
5. The Gain Deferral Method is adopted for all Section 721(c) Property subsequently contributed to the Section 721(c) Partnership by the U.S. Transferor and all other U.S. Transferors that are Related Persons until the earlier of: (i) the date that no Built-in Gain remains with respect to any Section 721(c) Property to which the Gain Deferral Method first applied; or (ii) the date that is 60 months after the date of the initial contribution of Section 721(c) Property to which the Gain Deferral Method first applied. (Notice 2015-54, Sec. 4.03)

The regs described in Notice 2015-54 will apply to transactions involving tiered partnerships in a manner consistent with the purpose of these rules as described in Notice 2015-54, Sec. 3.(Notice 2015-54, Sec. 4.04)

Upon an Acceleration Event with respect to an item of Section 721(c) Property, a U.S. Transferor must recognize gain in an amount equal to the remaining Built-in Gain that would have been allocated to the U.S. Transferor if the Section 721(c) Partnership had sold the item of Section 721(c) Property immediately before the Acceleration Event for its fair market value.The regs will provide for corresponding adjustments to the basis of the Section 721(c) Property and the U.S. Transferor’s partnership interest to reflect the recognition of the remaining Built-In Gain.An Acceleration Event with respect to an item of Section 721(c) Property may require a U.S. Transferor to recognize only a portion of the remaining Built-in Gain.(Notice 2015-54, Sec. 4.05(2))

An Acceleration Event will not occur if (i) a U.S. Transferor transfers an interest in a Section 721(c) Partnership to a domestic corporation in a transaction to which either Code Sec. 351(a) or Code Sec. 381(a) applies, or (ii) a Section 721(c) Partnership transfers an interest in a lower-tier partnership that owns Section 721(c) Property to a domestic corporation in a transaction to which Code Sec. 351(a) applies, provided that in both cases the parties continue to apply the Gain Deferral Method by treating the transferee domestic corporation as the U.S. Transferor for all purposes under Notice 2015-54.(Notice 2015-54, Sec. 4.05(4))

An Acceleration Event will not occur if a Section 721(c) Partnership transfers Section 721(c) Property to a domestic corporation in a transaction to which Code Sec. 351(a) applies.If a Section 721(c) Partnership transfers Section 721(c) Property (or an interest in a partnership that owns Section 721(c) Property) to a foreign corporation in a transaction described in Code Sec. 351(a), an Acceleration Event will not occur to the extent the Section 721(c) Property is treated as being transferred by a U.S. person (other than a domestic partnership) under Reg. § 1.367(a)-1T(c)(3)(i) or Reg. § 1.367(a)-1T(c)(3)(ii).The stock in a transferee corporation received by a Section 721(c) Partnership in a transaction described in Notice 2015-54, Sec. 4.05(4) will not be subject to the Gain Deferral Method.(Notice 2015-54, Sec. 4.05(4))

IRS also intends to issue regs providing that, as an additional requirement for applying the Gain Deferral Method, a U.S. Transferor (and, in certain cases, a Section 721(c) Partnership) must extend the period on limitations of assessment of tax with respect to all items related to the Section 721(c) Property contributed to the Section 721(c) Partnership through the close of the eighth full tax year following the tax year of the contribution.The regs will not require the extension of the period of limitations for tax years that end before the date of publication of the regs. (Notice 2015-54, Sec. 4.06(3))

Reporting.If a Section 721(c) Partnership is a foreign partnership, a U.S. Transferor (or a domestic partnership in which a U.S. Transferor is a Direct or Indirect Partner) must fulfill any reporting requirements imposed under sections 6038, 6038B, and 6046A and the existing regulations thereunder with respect to the contribution of the Section 721(c) Property to the Section 721(c) Partnership.IRS intends to modify Schedule O, Transfer of Property to a Foreign Partnership, of Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships), or its instructions, for tax years beginning in 2015 to require supplemental information for contributions of Section 721(c) Property to Section 721(c) Partnerships.(Notice 2015-54, Sec. 4.06(1))

IRS also intends to issue regs describing additional reporting requirements for a U.S. Transferor for each tax year in which the Gain Deferral Method applies; these regs will not require any new filings for tax years that end before the date of publication of the regs. (Notice 2015-54, Sec. 4.06(2))

Code Sec. 482 regs to be issued.In Notice 2015-54, IRS said it intends to issue regs that provide specified methods for controlled transactions based on the specified methods in Reg. § 1.482-7(g) (which provides methods for evaluating the arm s length amount charged) appropriately adjusted in light of the differences in the facts and circumstances between such partnerships and cost sharing arrangements.The regs will provide periodic adjustment rules that are based on the principles of Reg. § 1.482-7(i)(6) for controlled transactions involving partnerships.The regs will provide that, in the event of a trigger based on a significant divergence of actual returns from projected returns for controlled transactions involving a partnership, IRS may make periodic adjustments to the results of such transactions under a method based on Reg. § 1.482-7(i)(6)(v), as appropriately adjusted, as well as any necessary corresponding adjustments to Code Sec. 704(b) or Code Sec. 704(c) allocations.

IRS is also considering issuing regs under Reg. § 1.6662-6(d) to require additional documentation for certain controlled transactions involving partnerships.(Notice 2015-54, Sec. 5)

Effective date.The regs in Notice 2015-54, Sec. 4.01 through Notice 2015-54, Sec. 4.06(1), Notice 2015-54, Sec. 4.07 (Examples), and Notice 2015-54, Sec. 4.08 (anti-abuse rules), will apply to transfers occurring on or after Aug. 6, 2015, and to transfers occurring before Aug. 6, 2015 that result from entity classification elections made under Reg. § 301.7701-3 that are filed on or after Aug. 6, 2015, and that are effective on or before Aug. 6, 2015.The reporting requirements described in Notice 2015-54, Sec. 4.06(2) and Notice 2015-54, Sec. 4.06(3), and the regs described in Notice 2015-54, Sec. 5, will apply to transfers and controlled transactions occurring on or after the date of publication of the regs.

References:For regulatory authority to provide for gain recognition on transfer to foreign partner, see FTC 2d/FIN ¶  B-1410.1  ; United States Tax Reporter ¶  7214.03  ; TaxDesk ¶  581,410  ; TG ¶  2056  .