In Notice 2015-54 (the “Notice”), released on August 6, 2015, the IRS announced that it intended to issue Treasury regulations under section 721(c) that would require certain U.S. persons to recognize gain upon the contribution of property to a partnership with a foreign partner related to that U.S. person unless the parties follow certain rules. The purpose of such regulations would be to combat what the IRS views as the potential to improperly shift gain on contributed property from a U.S. person to a foreign person that is not subject to U.S. tax. Any future Treasury regulations issued in accordance with the Notice will be retroactive so as to be effective as of the date of the Notice.
This update summarizes certain key provisions in the Notice that may be relevant to your business.
The Treasury regulations, as described in the Notice, essentially will deny non-recognition treatment under section 721(a) with respect to contributions by a U.S. person of “Section 721(c) Property” to a “Section 721(c) Partnership” unless the parties apply the “Gain Deferral Method” (“GDM”). The IRS is invoking its authority under section 721(c), which permits the issuance of Treasury regulations that override the general non-recognition rule of section 721(a) for contributions to partnerships. These Treasury regulations would operate alongside additional Treasury regulations under section 482 for covered transactions involving partnerships that the Notice indicates the IRS intends to issue.
Before 1997, sections 1491 through 1494 imposed an excise tax on contributions of appreciated property by U.S. persons to foreign partnerships. These rules imposed the tax on the amount of gain inherent in the property but not recognized at the time of the transfer. At the time of the repeal of sections 1491 through 1494, however, Congress gave Treasury the explicit authority under section 721(c) to issue regulations with respect to contributions to partnerships. The IRS is now exercising this authority to address contributions of appreciated property to certain partnerships with foreign partners that would otherwise qualify for non-recognition treatment.
Under existing law, section 704(c) requires a partnership to allocate items of income, gain, loss and deduction with respect to contributed property in a manner that takes into account the difference between the tax basis of the property and its fair market value at the time of the contribution. Before the Notice, a partnership could adopt any reasonable method of allocating items with respect to the built-in gain or loss, including three methods described in the Treasury regulations. Under the Treasury regulations described in the Notice, the IRS now will require the use of the remedial method for the contributions of appreciated property described in the Notice in order for the contribution to qualify as a non-recognition transaction under section 721(a). Under the remedial allocation method, the partnership must allocate items of income, gain, loss or deduction to the contributing partner to offset any book/tax disparity of allocations to non-contributing partners. The items allocated to the contributing partner may be completely fictional. As a result, the remedial allocation method may result in the allocation of phantom gain to the contributing partner, which would not happen under the other two methods set forth in the Treasury regulations.
II. Section 721(c) Property
The Notice defines Section 721(c) Property as property with built-in gain (i.e., property whose section 704(c) book value exceeds its tax basis at the time of the contribution). Built-in gain created by periodic revaluations by the partnership (e.g., due to book-up events under the section 704(b) regulations) will not be taken into for the purposes of these rules. Also excluded from Section 721(c) Property would be cash equivalents, securities as defined in section 475(c)(2) and tangible property with a built-in gain of $20,000 or less. In addition, under a de minimis rule, section 721(a) will continue to provide non-recognition treatment for contributions of property with built-in gain if: (1) the built-in gain in all Section 721(c) Properties contributed in the same year by a U.S. partner (or a group of related U.S. partners) does not exceed $1 million; and (2) the partnership is not otherwise applying the GDM with respect to a prior contribution by such U.S. partner (or a group of related U.S. partners).
III. Section 721(c) Partnership
A Section 721(c) Partnership is a partnership to which a U.S. partner contributes Section 721(c) Property if (i) a foreign person that is not itself a partnership owns a direct or indirect interest in the partnership and is related, within the meaning of section 267(b) or 707(b)(1), to the U.S. partner, and (ii) the U.S. partner and related persons own more than 50% of the interests in partnership capital, profits, losses or deductions.
IV. The GDM
In order for contributions of Section 721(c) Property to qualify for non-recognition treatment under section 721(a), the partnership must apply the GDM to the Section 721(c) Property. The GDM has five requirements that must be satisfied:
- First, the partnership must adopt the remedial allocation method under section 704(c) for all built-in gains with respect to all Section 721(c) Property contributed pursuant to the same plan by the U.S. partner (or a group of related U.S. partners);
- Second, during any taxable year that there is remaining built-in gain with respect to the Section 721(c) Property, all section 704(b) items of income, gain, loss and deduction with respect to that Section 721(c) Property must be allocated in the same proportion (e.g., items of income from such property cannot be allocated 70-30 if the deductions are allocated 50-50);
- Third, additional reporting requirements must be satisfied;
- Fourth, the GDM must be used with respect to all Section 721(c) Property subsequently contributed to the partnership by the U.S. partner and persons related to the U.S. partner unless the subsequent contribution is made after the earlier of (1) the date that no built-in gain remains with respect to any other Section 721(c) Property subject to the GDM or (2) the date that is 60 months after the initial contribution of the Section 721(c) Property to which the GDM first applied; and
- Finally, the transferring U.S. partner must recognize any remaining built-in gain upon an “Acceleration Event” (as discussed below).
In addition, the IRS intends to require the relevant parties to extend the statute of limitations for assessments with respect to the Section 721(c) Property if the GDM is selected. The extension would last until eight years after the contribution. This requirement will not be effective retroactively.
V. Acceleration Events and Reporting
An Acceleration Event can occur if any party enters into any transaction that would reduce or could defer the amount of any remaining built-in gain in a Section 721(c) Property that the U.S. partner otherwise would recognize under the GDM had the transaction not occurred. For example, the sale by the U.S. partner of its interest in the partnership would cause an Acceleration Event. Nevertheless, an Acceleration Event does not include a contribution by the partnership to a domestic corporation in a section 351(a) transaction or the contribution to a foreign corporation to the extent the Section 721(c) Property is treated a transferred by U.S. person (other than a partnership) under section 1.367(a)-1T(c)(3)(i) or (ii). Similarly, an Acceleration Event does not include a transfer by a U.S. partner of its interest in a Section 721(c) Partnership to a domestic corporation in a section 351(a) or section 381(a) transaction, or a transfer by a Section 721(c) Partnership of an interest in a lower-tier partnership to a domestic corporation in a section 351(a) transaction, if the parties continue to apply the GDM by treating the domestic corporation as the original U.S. transferor for all purposes of the Notice.
An Acceleration Event with respect to all Section 721(c) Property will be deemed to occur if the partnership or any party fails to comply with the applicable GDM rules. Thus, a partnership could inadvertently trigger an Acceleration Event by not applying the GDM to additional contributions of Section 721(c) Property.
In terms of reporting requirements, for the 2015 tax year, U.S. partners contributing Section 721(c) Property to a foreign partnership will have to report on Form 8865 if they are using the GDM with respect to such contributions. The IRS intends to impose additional reporting requirements in the Treasury regulations, but such reporting requirements will not be effective until such regulations are issued.