IRS Issues Regs. on Interest Expense Allocation and Apportionment for Partners

The IRS has issued temporary and identical proposed regulations that make four changes to the rules for allocating and apportioning interest expense for partners in partnerships (T.D. 9571;  REG-113903-10).

The first change is to the method for apportioning interest expense for corporate partners whose interest in the partnership is 10% or more. Those partners are required to apportion their share by reference to the partnership’s assets (the aggregate method). Under the new regulations, the corporation must allocate its distributive share of partnership interest and its unrelated interest expense to all of its assets, including its proportionate share of partnership assets. Under the existing regulations, the corporation was only required to apportion its distributive share of partnership interest in this fashion. In addition, under the existing regulations, corporate partners could use the tax-book-value method or the fair-market-value method to do this calculation. The new regulations permit corporate partners to use the alternative-tax-book-value method in addition to the other methods. (The alternative-tax-book-value method is defined in Regs. Sec. 1.861-9(i).)

The temporary regulations also add the requirement that, when determining the value of the assets using the tax-book-value or the alternative-tax-book-value methods, 10% or greater corporate partners must use the inside basis of the assets, including any Sec. 734(b) adjustment (adjustment to basis of undistributed partnership property) or Sec. 743(b) adjustment (adjustment to basis of partnership property upon transfer of partnership interest) (Temp. Regs. Sec. 1.861-9T(e)(2)).

The second change requires individuals who are general partners or who are limited partners holding an interest of 10% or more using the tax-book-value or the alternative-tax-book-value methods to also include any Sec. 734(b) or Sec. 743(b) adjustments in making those calculations.

The third change fixes a problem in the way taxpayers were applying the existing regulations in determining the fair market value (FMV) of assets. The IRS had determined that taxpayers were interpreting the FMV method, which requires related-party debt to be excluded as an asset as part of the process for determining total intangible asset value, as meaning that the debt also is not treated as an asset in the hands of the taxpayer for the broader purpose of applying the asset method. In addition, for purposes of valuing the stock in related persons, some taxpayers took the position that those rules excluded related-party debt as an asset (because of the reference in Temp. Regs. Sec. 1.861-9T(h)(4) to Temp. Regs. Sec. 1.861-9T(h)(1)(ii)), but permitted the value of stock in the related-person obligor to be reduced by the amount of the related-party debt as a liability (because the existing language of Temp. Regs. Sec. 1.861-9T(h)(4)(ii) did not limit the reduction for liabilities to unrelated-party liabilities). The IRS amended Temp. Regs. Sec. 1.861-9T(h)(4) to reflect the fact that related-party debt is an asset of the creditor that must be taken into account whether held by the taxpayer or a related person.

The fourth change is to Temp. Regs. Sec. 1.861-11T to reflect a statutory amendment of Sec. 864(e)(5)(A) to provide that a foreign corporation is treated as a member of an affiliated group for interest allocation and apportionment purposes if more than 50% of its gross income is effectively connected income and at least 80% of the vote or value of its stock is owned by the affiliated group. In that case, all of the foreign corporation’s assets and interest expense are taken into account for purposes of applying the interest apportionment rules.

The regulations are effective January 17, 2012. The two changes relating to corporate partners apply to tax years beginning after that date. The amendment to Temp. Regs. Sec. 1.861-9T(h)(4) applies to tax years ending on or after that date. The changes to Temp. Regs. Sec. 1.861-11T apply to tax years beginning after August 10, 2010.