In Notice 2015-54, the IRS and Treasury announced forthcoming regulations (with an Aug. 6, 2015, effective date) under Sec. 721(c) that will create an exception to the general nonrecognition rule for property contributions to a partnership in exchange for a partnership interest under Sec. 721(a). In particular, the exception to Sec. 721(a) would apply when a U.S. person (a U.S. transferor) contributes appreciated property (Sec. 721(c) property) to a partnership, if, after the contribution and any related transactions: (1) one or more related foreign persons (generally defined as a person related to the U.S. transferor under Sec. 267(b) or 707(b)) is a "direct or indirect partner" in the partnership, and (2) the U.S. transferor and one or more related persons own more than 50% of the interests in partnership capital, profits, deductions, or losses (a Sec. 721(c) partnership).
The IRS and Treasury intend that the regulations will ensure that a U.S. transferor of Sec. 721(c) property to a Sec. 721(c) partnership takes into account (either immediately or periodically) the built-in gain attributable to the Sec. 721(c) property.
The IRS and Treasury also announced their intent to issue modified regulations specific to partnerships under Secs. 482 and 6662 to address controlled transactions involving partnerships and the appropriate transfer-pricing methods, valuation approaches, periodic adjustment provisions, and documentation of those transactions.
Sec. 721(c) grants Treasury the regulatory authority to prevent the general nonrecognition rule of Sec. 721(a) from applying to the "gain realized on the transfer of 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." Before issuing Notice 2015-54, the IRS and Treasury had not issued, or announced their intent to issue, regulations under Congress's grant of authority under Sec. 721(c). According to Notice 2015-54, the IRS and Treasury have become aware that some taxpayers claim to be able to contribute, consistent with Secs. 704(b), 704(c), and 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. income tax.
Notice 2015-54 states that Treasury and the IRS believe that in some cases partnership transactions involving special allocations lead to inappropriate results and are aware that certain taxpayers may be valuing property contributed to partnerships, or the property or services involved in related controlled transactions, in a manner contrary to Sec. 482. As a result, the notice indicates that partnership interests or consideration received in controlled transactions also may be incorrectly valued, thereby reducing the amount of income or gain allocated to U.S. partners. The notice cites as an example a partnership agreement providing a domestic partner with a fixed preferred interest in exchange for the contribution of an intangible that is assigned a value that is inappropriately low, coupled with a special allocation of a greater share of the income from the intangible to a related foreign partner.
The notice specifically states that many of the taxpayers engaging in those transactions are choosing a Sec. 704(c) method other than the remedial allocation method and/or using valuation techniques that are inconsistent with the arm's-length standard. To restrict taxpayers from engaging in those transactions and potentially shifting gain to a foreign person through the use of a partnership, the IRS and Treasury determined that it is appropriate to allow for the continued application of Sec. 721(a) to transfers to partnerships with related foreign partners only when the conditions described in the notice are satisfied.
Immediate gain recognition and exceptions to gain recognition: According to Notice 2015-54, the regulations under Sec. 721(c) will provide that Sec. 721(a)'s general nonrecognition treatment will not apply (i.e., there will be immediate gain recognition) when a U.S. transferor contributes Sec. 721(c) property to a Sec. 721(c) partnership. For purposes of determining whether a partnership is a Sec. 721(c) partnership, a "related person" is a person that is related to the U.S. transferor under Sec. 267(b) or 707(b)(1). A "related foreign person" is a related person (other than a partnership) that is not a U.S. person. A "direct or indirect partner" is a person that owns an interest in a partnership directly or indirectly through one or more partnerships. In addition, Sec. 721(c) property does not include (1) cash equivalents, (2) securities under Sec. 475(c)(2) (including stock of controlled foreign corporations), and (3) tangible property with built-in gain of $20,000 or less.
The Sec. 721(c) regulations will apply to transactions involving tiered partnerships in a manner consistent with the purpose of these rules as described in the notice. In this regard, (1) if a U.S. transferor is a direct or indirect partner in a partnership and that partnership contributes Sec. 721(c) property to a lower-tier partnership, or (2) if a U.S. transferor contributes an interest in a partnership that owns Sec. 721(c) property to a lower-tier partnership, then the rules described in the notice will apply as though the U.S. transferor had contributed its share of the Sec. 721(c) property directly.
Notice 2015-54 provides two exceptions to the application of the general rule. First, U.S. transferors transferring Sec. 721(c) property to a Sec. 721(c) partnership will be able to defer their gain if the "gain deferral method" (described below) applies to the contributed Sec. 721(c) property. Second, Sec. 721(a) will continue to apply (i.e., there will not be immediate gain recognition) if the sum of all Sec. 721(c) property contributed by the U.S. transferor during the tax year does not exceed $1 million and the partnership is not applying the gain deferral method to prior contributions by the U.S. transferor or a related U.S. transferor (the de minimis rule).
Gain deferral method: The gain deferral method has five requirements:
1. The partnership must adopt the remedial allocation method described in Regs. Sec. 1.704-3(d) for the contributed Sec. 721(c) property;
2. For any tax year in which there is remaining built-in gain with respect to the contributed Sec. 721(c) property, the partnership must allocate all items of Sec. 704(b) book income, gain, loss, and deduction for that property in the same proportion (the proportionate allocation rule);
3. The partnership must comply with certain reporting requirements as described below;
4. The U.S. transferor must recognize the built-in gain upon an "acceleration event" in accordance with the rules described in Notice 2015-54; and
5. The partnership must adopt the gain deferral method for all Sec. 721(c) property subsequently contributed to the partnership by the U.S. transferor and all related U.S. transferors until the earlier of (1) when no built-in gain remains on any Sec. 721(c) property to which the gain deferral method first applied; or (2) 60 months after the initial contribution to which the gain deferral method applied.
Acceleration events: An acceleration event is any transaction that would reduce the amount of remaining built-in gain that a U.S. transferor would recognize under the gain deferral method or could defer the recognition of the built-in gain. Notably, an acceleration event is deemed to occur with respect to all Sec. 721(c) property at any time that the partnership does not satisfy the requirements of the gain deferral method. An acceleration event also occurs upon the sale by a U.S. transferor of a Sec. 721(c) partnership interest. If a U.S. transferor sells only part of its interest in a Sec. 721(c) partnership, the U.S. transferor would have an acceleration event only to the extent of the Sec. 721(c) property attributable to the partnership interest sold.
Certain transfers are not treated as acceleration events under the notice. These include transfers of Sec. 721(c) partnership interests or Sec. 721(c) property to a domestic corporation in a Sec. 351 or 381 transaction and the transfer of Sec. 721(c) property to a foreign corporation in a Sec. 351 transaction if the assets are treated as being transferred by a U.S. person (other than a domestic partnership) under Temp. Regs. Sec. 1.367(a)-1T(c)(3)(i) or (ii). To meet the exception for a transfer of a Sec. 721(c) partnership interest to a domestic corporation, the parties must continue to apply the gain deferral method by treating the transferee domestic corporation as the U.S. transferor.
Upon the occurrence of an acceleration event, the U.S. transferor recognizes the portion of the remaining built-in gain that would have been allocated to the U.S. transferor if the partnership had sold the Sec. 721(c) property immediately before the acceleration event for its fair market value. To reflect the U.S. transferor's recognition of gain, corresponding adjustments are made to the basis of the Sec. 721(c) property and to the U.S. transferor's basis in its partnership interest.
Anti-abuse rule: Notice 2015-54 includes an anti-abuse rule providing that, if a U.S. transferor engages in a transaction (or a series of transactions) with a principal purpose of avoiding the application of the regulations described in the notice, then the IRS may disregard or recharacterize the transaction (or series of transactions) in accordance with its substance.
Reporting requirements and statute of limitation: U.S. transferors contributing Sec. 721(c) property to a foreign Sec. 721(c) partnership must fulfill the reporting requirements of Secs. 6038, 6038B, and 6046A. Also, for tax years beginning in 2015, the IRS intends to modify Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships (specifically, Schedule O, Transfer of Property to a Foreign Partnership), or its instructions, related to the transfer of property to a foreign partnership. Finally, for all partnerships, the IRS and Treasury intend to issue additional reporting requirements for future tax years.
Regarding the statute of limitation, the notice states that the IRS and Treasury intend to issue regulations that will require a U.S. transferor (and, in some cases, a Sec. 721(c) partnership) to extend the statute of limitation for all items related to the Sec. 721(c) property through the close of the eighth tax year following the year of the contribution.
Sec. 482 scope: Notice 2015-54 emphasizes in Section 2.04that, "[f]or purposes of section 482, [Regs. Secs.] 1.482-1(i)(7) and (8) provide that controlled transactions include contributions" to partnerships. As such, the notice indicates that the IRS and Treasury believe that the provisions of Sec. 482 and the regulations adopted under Sec. 482 (including regulations that establish the arm's-length standard, the best method rule, and various specified methods applicable to intangible property) currently apply to contributions to partnerships.
In general, the regulations under Sec. 721(c) will apply to transfers occurring on or after Aug. 6, 2015, as well as to transfers treated as occurring before Aug. 6, 2015, resulting from check-the-box elections that are filed on or after, but are effective on or before, that date. For contributions occurring before the issuance of new regulations, Notice 2015-54 states the IRS and Treasury believe that the current regulations under Secs. 482 and 6662 apply to partnership contributions, distributions, partnership interests, and allocation of other partnership items. The regulations on future reporting obligations and the extensions of the statute of limitation, as well as the regulations further defining the application of Secs. 482 and 6662 to partnerships, will be effective on or after the date the regulations are published.
Effective immediately, taxpayers transferring appreciated property to a foreign or domestic partnership meeting the definition of a Sec. 721(c) partnership will need to ensure that the transfer meets the de minimis rule or that they properly adopt and apply the gain deferral method. In that regard, Notice 2015-54 may raise the stakes in determining whether an arrangement between related taxpayers is classified as a partnership for U.S. federal income tax purposes.
Adopting the remedial allocation method (as required by the gain deferral method) will generally cause the inclusion of taxable income equal to the built-in gain in the Sec. 721(c) property over its applicable recovery period. Modeling of income or loss under the potential Sec. 704(c) methods has long been common in assessing partnership contributions, and partnerships affected by this new guidance will need to model the effect of the remedial allocation method on the U.S. transferor.
The proportionate allocation rule (also required by the gain deferral method) raises significant questions of interpretation. The intent seems straightforward—to require "straight-up" allocations of income and loss with respect to the Sec. 721(c) property. But, in practice, it is likely that many questions will arise. For example, the allocation of remedial income will typically alter the allocation of foreign tax expense, which, in turn, typically requires corrective allocations to ensure that the partners' capital accounts remain in balance. Another example is posed by nonrecourse deductions, which may be mandatorily allocated in a manner that differs from the general sharing allocations stated in the partnership agreement. Treasury and the IRS do not appear to have intended that following the above regulatory allocation rules would trigger built-in gain with respect to Sec. 721(c) property, and, hopefully, they will clarify the parameters of the proportionate allocation rule promptly.
Notice 2015-54 defines an acceleration event broadly. Until the IRS and Treasury issue regulations under Sec. 721(c), there will be significant uncertainty as to what transactions constitute an acceleration event. It is clear that distributions of Sec. 721(c) property could constitute an acceleration event; in certain cases, it will be necessary to monitor the property even beyond the seven-year period included in the "mixing bowl" rules of Secs. 704(c)(1)(B) and 737. The sale of a partnership interest by a U.S. transferor would also cause an acceleration event. This raises the possibility of a U.S. transferor's recognizing built-in gain even when the sale of its partnership interest would not otherwise result in a taxable gain. The rule is written so broadly that it could, in theory, apply to even a small change in the timing of the recognition of taxable income, such as an accounting method change that extends the recovery period of property. As with the proportionate allocation rule, it is hoped that the definition of an acceleration event will be clarified, as the adverse consequences of an error are significant.
Careful attention needs to be paid to the valuation of contributed property (both intellectual property (IP) and property in any other form) to a partnership. As discussed, Notice 2015-54 emphasizes that Sec. 482 currently applies to transactions between related parties, which implies that the methods specified under Regs. Sec. 1.482-4 are currently specified methods for those partnerships. Notice 2015-54 further indicates that the IRS and Treasury intend to adopt regulations that will use valuation methods specified under Regs. Sec. 1.482-7 to address contributions of IP to partnerships (though Notice 2015-54 notes that the IRS could apply those regulations now as unspecified methods, as permitted under the best method rule). Consequently, taxpayers should consider whether their current IP valuation methods yield results similar to valuations conducted under the methods specified in Regs. Secs. 1.482-4 and 1.482-7, including the comparable uncontrolled transaction method, comparable profits method, the income method, the acquisition price method, the market capitalization method, and the residual profit split method.
Careful analysis of the returns from the applicable partnership interests will be required to ensure that these returns are consistent with Sec. 482 principles. Taxpayers should also consider (1) the advisability of adopting adjustable payment provisions that could avoid the possibility of periodic adjustments under either Regs. Sec. 1.482-4(f)(2) or 1.482-7(i)(6); and (2) the need for documentation under Regs. Sec. 1.6662-6(d) to protect against penalties under Secs. 6662(e) and (h).
In addition, the scope of the regulations to be issued regarding the application of Sec. 482 principles to partnerships is uncertain. Notice 2015-54 does not indicate that these regulations would apply only to controlled transactions involving Sec. 721(c) property. It is possible that these could be rules of general application to transactions between partners that are related parties. If so, similar considerations to those described above could apply to all transfers of property to partnerships between related parties.
For partnerships formed before the issuance of Notice 2015-54, taxpayers should consider whether the relationship between their partnership contributions and partnership interests, as well as their ongoing interactions with the partnership, comply with Sec. 482. Given that Notice 2015-54 emphasizes the applicability of Sec. 482 to partnerships, it is to be expected that the IRS will audit both preexisting and new partnerships for compliance with Sec. 482, which will implicate various transfer-pricing concepts, including the arm's-length standard, the best method rule, and the intangible property regulations of Regs. Secs. 1.482-4 and 1.482-7.
Finally, the scope and application of the anti-abuse rule are unclear. Specifically, it is unclear what facts or conditions would lead to a conclusion that a transaction (or series of transactions) had a principal purpose of avoiding the application of the regulations described in the notice.
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.