Chief Counsel Advice 201917007
In a redacted Chief Counsel Advice (CCA), IRS has determined that it had the authority under Reg § 1.701-2(e) to treat a partnership as aggregate of its partners since it was appropriate to carry out purposes of Code Sec. 367(d). IRS also concluded that the taxpayer couldn’t rely on the disposition rule exception in Reg § 1.367(d)-1T(e)(1) becasue it only applied to the extent a related U.S. person was available to succeed to Code Sec. 367(d) ‘s general inclusion rule. But, IRS found that applying the definition of domestic partnership in Code Sec. 7701(a)(4) — which would allow the partnership to be treated as a related U.S. person — was improper because it was manifestly incompatible with Code Sec. 367(d)‘s intent.
Background on Section 367(d). Code Sec. 367(d) provides the general framework for the taxation of certain outbound transfers of intangible property. Code Sec. 367(d)(1) provides that, except as provided in regs, if a U.S. transferor transfers intangible property to a foreign corporation in an exchange described in Code Sec. 351 or Code Sec. 361, Code Sec. 367(d) applies rather than Code Sec. 367(a).
Code Sec. 367(d)(2)(A) provides that a U.S. transferor that transfers intangible property subject to Code Sec. 367(d) is treated as having sold the property in exchange for payments that are contingent upon the productivity, use, or disposition of the property. Under Code Sec. 367(d)(2)(A), despite the nonrecognition treatment accorded under Code Sec. 351 or Code Sec. 361, the U.S. transferor is treated as having sold the intangible property in exchange for contingent payments.
Code Sec. 367(d)(2)(A)(ii) provides that the contingent payments that the U.S. transferor is treated as receiving must be taken into account in one of two ways. Under the general rule of Code Sec. 367(d)(2)(A)(ii)(I), the U.S. transferor is treated as receiving amounts which reasonably reflect the amounts which would have been received annually over the useful life of the intangible property. Under the disposition rule of Code Sec. 367(d)(2)(A)(ii)(II), in the case of a direct or indirect disposition of the intangible property, the U.S. transferor is treated as receiving the amount that would have been received upon a disposition of such property. Thus, the disposition rule requires the U.S. transferor to recognize an amount based on the value of the intangible at the time of the disposition.
Reg § 1.367(d)-1T(e)(1) provides that if a U.S. person transfers intangible property in a transaction subject to Code Sec. 367(d) and “within the useful life of the transferred intangible property, that U.S. transferor subsequently transfers the stock of the transferee foreign corporation to U.S. persons that are related to the transferor” then the related U.S. persons may succeed to the general rule inclusion. Reg § 1.367(d)-1T(e)(3)provides that if a U.S. person transfers intangible property to a foreign corporation and the U.S. transferor later transfers stock of the transferee to one or more related foreign persons, then the U.S. transferor will continue to include in income annually the general rule inclusions as if the subsequent transfer had not occurred.
Reg § 1.367(d)-1T(e) only applies when each of the following steps occurs: (i) a U.S. person transfers intangible property to a foreign corporation in an exchange under Code Sec. 351 or Code Sec. 361; (ii) the U.S. transferor subsequently transfers the stock of the foreign corporation to one or more foreign persons related to the transferor; and (iii) the U.S. transferor continues to include in income the deemed royalty payments as if the stock transfer had not occurred.
The disposition rule exception in Reg § 1.367(d)-1T(e)(1) only applies if a U.S. transferor “subsequently transfers the stock of the transferee foreign corporation to U.S. persons that are related to the transferor.” For purposes of applying this rule, it is thus necessary to determine who is considered a U.S. person. The regs define the term “United States person” by reference to Code Sec. 7701(a)(30), which lists a “domestic partnership” among other enumerated U.S. persons. (Reg § 1.367(a)-1(d)(1)) The regs provide a general cross-reference to Code Sec. 7701 for definitions of the enumerated terms, but do not explicitly incorporate the definition of a “domestic partnership” in Code Sec. 7701(a)(4). So although the regs define a U.S. person to include a domestic partnership, they do not explicitly define what constitutes a domestic partnership. This stands in contrast to the regs’ approach to corporations, as Reg § 1.367(a)-1(d)(2) defines a “foreign corporation” to have the same meaning as provided in Code Sec. 7701(a)(3) and Code Sec. 7701(a)(5). Accordingly, the term “domestic partnership” as used in the regs under Code Sec. 367 is determined by reference to Code Sec. 7701 generally.
Code Sec. 7701 provides definitions for all purposes of the Code “where not otherwise distinctly expressed or manifestly incompatible with the intent thereof.” To the extent not manifestly incompatible with the Code, the term “domestic” is defined to mean “created or organized in the United States or under the law of the United States or of any State unless, in the case of a partnership, the Secretary provides otherwise by regulations.”
Background on partnership anti-abuse rule. Except as described below, IRS may treat a partnership as an aggregate of its partners (in whole or in part) as appropriate in order to carry out the purpose of any provision of the Code or regs. (Reg § 1.701-2(e)(1))
However, IRS may not treat a partnership as an aggregate to the extent that: (1) a Code or reg provision prescribes the treatment of a partnership (in whole or in part) as an entity (Reg § 1.701-2(e)(2)(i); first prong); and (2) that treatment and the ultimate tax results, taking into account all the relevant facts and circumstances, are clearly contemplated by that provision. (Reg § 1.701-2(e)(2)(ii); second prong)
CCA’s conclusion. In the CCA, IRS asserted the partnership anti-abuse rule under Reg § 1.701-2(e)(1), treating a partnership as an aggregate of its partners, in order to carry out the purpose of Code Sec. 367(d) by ensuring that the outbound transfer of intangible property was subject to U.S. tax.
IRS rejected the Taxpayer’s contention that Code Sec. 7701(a)(4) defined the term domestic with respect to a partnership unless IRS provided otherwise by regs, and that, as no such regs had been issued, Code Sec. 7701(a)(4) applied. IRS pointed out that this argument implied that even if the Code Sec. 7701(a)(4) definition of “domestic” was manifestly incompatible with the intent of the Code, it still applied unless and until IRS otherwise issued regs. IRS rejected such a construction, as it contradicted the plain language of Code Sec. 7701. IRS found that the construction of Code Sec. 7701 was clear — the enumerated definitions do not apply if they are “manifestly incompatible” with the intent of the Code.
The unequivocal purpose of Code Sec. 367(d) was to address the specific and unique problems with respect to outbound transfers of intangible property by requiring the U.S. transferor to recognize income attributable to the intangible property, either over time or immediately in a lump sum (in the case of a disposition of the intangible property). The specific purpose implicated by Reg § 1.367(d)-1T(e)(1) was to preserve the general rule inclusions if an appropriate related U.S. person was able to step into the shoes of the original transferor and recognize the income attributable to the intangible property. The rule merely acknowledged that a transfer to a related person did not change the ultimate economic ownership of the intangible property, and accordingly allowed that related person to continue paying tax on the income. In effect, the successor rule preserves the inclusion when the substance of ownership is unaffected but the form is altered.
IRS reasoned that the second prong (i.e., Reg § 1.701-2(e)(2)(ii)) was satisfied if, taking into account all the relevant facts and circumstances, the tax results of treating the partnership as an entity rather than an aggregate were clearly contemplated. IRS concluded that there was no reasonable argument that Code Sec. 367(d) or Reg § 1.367(d)-1T(h) clearly contemplated the permanent, complete avoidance of U.S. tax with respect to an outbound transfer of intangible property under Code Sec. 367(d). A review of the statutory language and related legislative history established that the statute and regs did not contemplate the treatment and tax results that Taxpayer sought to achieve. Over eighty years of legislative and administrative development made it clear that the exact opposite result was intended by Congress. Taxpayer’s position plainly contradicted the clear purpose of Code Sec. 367(d): ensuring U.S. taxation of certain assets that otherwise would leave U.S. taxing jurisdiction in a nonrecognition transaction.
Taxpayer’s position purported to obtain tax results that were directly contrary to Congressional intent and the overarching purpose of the implementing regs. Accordingly, the second prong of the limitation was not satisfied, and IRS wasn’t prevented from asserting the abuse of entity rule in Reg § 1.701-2(e).
The disposition rule exception that Taxpayer relies on in Reg § 1.367(d)-1T(e)(1) only applied to the extent a related U.S. person was available to succeed to the general rule inclusion. Taxpayer relied on the definition in the Code. However, the definitions of Code Sec. 7701 only applied to the extent they were not manifestly incompatible with the intent of the Code. Here, the application of the definitions of Code Sec. 7701 for purposes of the successor rules was manifestly incompatible with the intent of Code Sec. 367(d) and the underlying regs. Accordingly, the definition in Code Sec. 7701 was not applicable.
References: For the rules applicable to transfers of intangibles to foreign corporations, see FTC 2d/FIN ¶F-6501; United States Tax Reporter ¶3674.03.
