As Seen in Law360
New Treasury regulations aimed at curbing the use of certain partnership transactions with respect to U.S. property held by controlled foreign corporations are not crystal clear on when the transactions will be deemed as possible tax avoidance measures and could discourage joint ventures between large multinational groups, experts say.
The Internal Revenue Service last week finalized rules that had been initially promulgated in September 2015 to limit the use of partnerships to invest in U.S. property when a CFC's investment in the same property became taxable under Section 956 of the Internal Revenue Code.
Experts agree that the final rules, in general, are sound tax policy aside from one section dealing with special allocations within partnerships. The IRS says that it will respect these special partnership agreements, in which profits and losses are allocated differently from invested capital, as long as they are not established primarily to avoid Section 956, and that it will take a facts and circumstances approach to review the economic substance of these allocations.
This rule could be problematic because special allocations often take tax obligations into consideration, and it is unclear when the revenue agency may deem them as a motive to avoid Section 956, according to Eric Sloan, a partner at Gibson Dunn.
"What the regulations give with one hand, they take away with another," Sloan said. "Most of the time, special allocations have a substantial tax motivation. Someone's doing some tax planning ... I think that taxpayers will be very nervous relying on that rule just because in many situations, the capital structure of these partnerships will be heavily taxinfluenced."
CFCs are corporations majorityowned by U.S. shareholders. U.S. tax law implemented in the 1960s includes provisions to prevent U.S. residents from using CFCs to avoid taxes on U.S. investments, but prior to 2015, the regulations did not extend to investments by partnerships backed by CFCs. CFCs could avoid taxes by using partnerships as a proxy to invest in U.S. assets, according to the IRS.
In addition to the final rules, the IRS contemporaneously issued new proposed regulations under which special allocations with respect to affiliated parties won't be able to escape Section 956. The proposed rules try to gauge the economic rationale behind special allocations amongst related parties and the notion of disregarding special allocations among related parties is a substantial and "breathtakingly new" development in the law that is not friendly to taxpayers, Sloan says.
"What it does at the end of the day is that it makes it more expensive, and one might imagine in certain situations, nearly prohibitively expensive, for joint ventures to be formed between large multinational groups, because typically when two corporations get together and want to form a joint venture, they want to take all the assets that relate to the business of the joint venture,” he said. “Anything that imposes costs on formation of joint ventures just makes it less likely that they will occur."
Ryan Dudley, a partner at Friedman LLP, says that the intent of the final regulations is to make it much more difficult for artificial arrangements to get around Section 956.
"There's always a question mark about how to apply rules that are based on facts and circumstances but I think using a liquidation basis only would potentially give rise to results that are inconsistent with the real economic outcomes of transactions between partners and partnerships," Dudley said. "These rules will in certain circumstances makes investments into partnerships that have substantial amounts of U.S. property more difficult but those types of transactions are fairly limited."
The final rules treat the obligation of a foreign partnership as an obligation of its partners by taking into account the partner's liquidation value percentage which is essentially the percentage of proceeds one would get if a partnership sold all its assets for cash and distributed the proceeds under a partnership agreement. This is a change from when the regulations were issued in 2015 at which time the partnerships obligations were based upon a partner's interest in profits.
The final regulations also treat loans by CFCs to partnerships, in several cases, as loans to the partners themselves. So, if a partner is based in the U.S., then the CFC will be treated as having made a loan to the U.S. entity, and therefore, an investment in U.S. property, thereby triggering a Section 956 inclusion.
"If a CFC makes a loan to foreign partnership, and the U.S. shareholder of the CFC is a partner in that partnership, that U.S. shareholder under an aggregate approach might have income inclusion as a result of that transaction," said Joe Calianno, a tax partner at BDO USA LLP.
The effective date of the final regulations goes back to September 2015 and this may end up catching some taxpayers in a situation where they can't undo their ownership of U.S. assets, Dudley says.
"It could result in an income inclusion that they weren't expecting," he said.