Tax News and Developments North America Baker & McKenzie 300 East Randolph Drive Suite 5000 Chicago, Illinois 60601, USA Tel: +1 312 861 8000 Fax: +1 312 861 2899 Client Alert October 20, 2016 New Regulations Significantly Change Partnership Disguised Sale and Debt Basis Rules New final, temporary, and proposed regulations drastically change the way partnership debt is treated for Code Section 707 "disguised sale" purposes and section 752 basis purposes. The primary changes in the regulations are: • The effective elimination of a partner's ability to use a guarantee to avoid disguised sale gain on a debt-financed distribution; • A heightened anti-abuse rule to challenge section 752 tax basis allocations from partner guarantees; • A nearly complete denial of tax basis allocations from a so-called "bottom dollar guarantee"; and • A series of "clean up" changes to the mechanics of the disguised sale rules and their exceptions, including the denial of benefits of an overlapping qualified liability and reimbursement for pre-formation expenditure exception. Background Law & Context By way of background, section 707 is intended to recharacterize certain contributions and distributions between partners and partnerships as a sale or exchange (i.e. a "disguised sale" transaction). The general rule is to find a disguised sale if the distribution would not have been made but for the contribution and there was not an intervening sharing of entrepreneurial risk. The regulations provide a rebuttable presumption that contributions and distributions within two years are recast as a disguised sale, however, the existing regulations provide several exceptions to disguised sale treatment, which are modified by the temporary regulations under sections 707 and 752. Related to section 707 is section 752, which dictates how partnership-level debt is allocated among the partners. As a general rule, nonrecourse debt is allocated in accordance with the way partners share profits, but for several special rules designed to specially allocate debt to partners to the extent needed to protect certain partners with low tax basis (often referred to as "negative tax capital"). In contrast, recourse debt is generally allocated to partners with the economic risk of loss ("EROL") on the debt. Partners often seek allocations of recourse and nonrecourse debt both to avoid triggering negative tax capital and to avoid disguised sales that can occur when debt is allocated away from a partner who contributed property subject to debt. To achieve a higher share of debt, a partner may seek EROL through a partner guarantee or some other payment obligation to the partnership. Under existing section 752 regulations, there is a presumption that a partner has an EROL with ©2016 B k & M K i All i ht d B k & Baker & McKenzie 2 Tax News and Developments – Client Alert October 20, 2016 regard to a payment obligation except to the extent the facts and circumstances evidence a plan to circumvent or avoid the obligation. In 2014, the Treasury and IRS released proposed regulations (the "2014 Proposed Regulations") decried by the tax community which would displace the facts and circumstances test with six hard requirements. Any payment obligation not satisfying all six requirements would be disregarded for purposes of determining whether a partner bore the EROL when allocating debt basis. These six requirements would apply to all payment obligations, even so-called deficit restoration obligations ("DRO") where a partner promises to repay a deficit in its capital account. Re-proposed regulations claim to address the glaring deficiencies and ambiguities found in the 2014 Proposed Regulations. The New 2016 Regulations The 707 Final Regulations The final section 707 regulations (the "2016 Final Regulations") provided numerous housekeeping-type changes to the mechanics of the disguised sale exceptions. The most significant change is the elimination of what the IRS viewed as "double dipping" for pre-formation expenditures financed by debt. The regulations also adopted a property-by-property rule for calculating the reimbursement for preformation capital expenditures exception to the disguised sales rules (the "RFPE Exception"), subject to aggregation in certain cases where separate accounting would be burdensome. Aggregation of multiple properties is possible under the 2016 Final Regulations to the extent (i) the total fair market value ("FMV") of the aggregated property is not more than the lesser of 10% of the FMV of all property, or $1 million, (ii) the partner uses a consistently-applied reasonable aggregation method, and (iii) the aggregation plan has a valid business purpose. Prior to the 2016 Final Regulations, a partner might contribute built-in gain property subject to a "qualified liability" used to finance property capital expenditures and avail itself of both the qualified liability exception and the RFPE exception to disguised sales. Thus under existing law the partner was perceived as "double dipping" by excluding from disguised sale proceeds both: (i) cash received as reimbursement of certain preformation capital expenditures with respect to the property, and (ii) an amount equal to the liability assumed by the partnership. The 2016 Final Regulations eliminate this perceived benefit by requiring partners to include into sale proceeds, cash distributions to the extent it was funded with qualified liability proceeds assumed by the partnership, but only to the extent of the excess of the partner's allocable share of the qualified liability. In coordination with the section 707 and 752 temporary regulations (the "Temporary Regulations"), the 2016 Final Regulations provide limitations on the available allocation methods under Treas. Reg. § 1.752-3(a)(3). Specifically, the 2016 Final Regulations retain the "significant item" method and "alternative method," but do not adopt the 2014 Proposed Regulation "liquidation value percentage" approach for determining partners' interests in partnership profits. The 2016 Final Regulations also provide a "step-in-the-shoes" rule for applying the RFPE Exception and for determining whether a liability is a qualified liability under Treas. Reg. § 1.707-5(a)(6). The qualified liability determination also applies to tiered-partnership structures where a contributing partner's share of a liability from a lower-tier partnership is treated as a qualified liability to the extent the liability would be a qualified liability had it been assumed or taken subject to by the upper-tier partnership in connection with a transfer of all of the lower-tier partnership's property to the upper-tier partnership by the lower-tier partnership. Baker & McKenzie 3 Tax News and Developments – Client Alert October 20, 2016 The 707 & 752 Temporary Regulations The Temporary Regulations modify the existing disguised sale exceptions, revise section 752 allocation methods for partnership liabilities, and effectively eliminate the use of "bottom dollar guarantees" ("BDGs"). Under the new Temporary Regulations, all partnership liabilities are treated as nonrecourse liabilities in applying the section 707 disguised sale rules except to the extent another partner bears EROL. This severely limits the use of the leveraged partnership structure because the contributing partner's share of the related partnership debt is determined solely in accordance with the partner's allocable share of partnership profits unaffected by any guarantees or similar obligations. Previously, under the debt-financed distribution exception to disguised sale treatment, a partner could receive a distribution of debt-funded cash while simultaneously contributing builtin gain property. This transaction was tax-deferred to the extent the amount of the distribution did not exceed the partner's allocable share of the liability incurred to fund the distribution—generally, this was the full amount of any debt guaranteed by the partner. The result of this deemed nonrecourse treatment under section 707 is significant. In the framework of a debt-financed distribution to a contributing partner, a partner's guarantee or other similar arrangement will no longer cause the partnership debt related to the debt-financed distribution to be allocated solely to such partner. Additionally problematic, if another partner guarantees the partnership debt, the contributing partner will be unable to even receive its nonrecourse sharing percentage of the partnership debt guaranteed by another partner. Thus, any cash proceeds in excess of the partner's allocable share of the partnership debt will be treated as an amount realized from a disguised sale (absent the application of another exception such as RFPE). The mechanics of this new rule are internally flawed in that even if partners guarantee debt in the same ratio as they share profits, the mechanic of carving out another partners guarantee means that the partners do not even receive their pro rata share of the debt. Hopefully this mechanic will be clarified by the IRS. Another material change is that the Temporary Regulations under section 752 disregard BDGs as an adequate means of creating an EROL but for two narrow exceptions. The two exceptions are (1) "vertical slice" guarantees (such as when two 50:50 partners each agree to cover half of each dollar of loan risk) and (2) bottom dollar guarantee arrangements where a partner retains ninety (90%) percent or more of the EROL. Finally, the Temporary Regulations under section 752 require partnerships to disclose BDGs on IRS Form 8275 in the taxable year in which the bottom-dollar payment obligation is undertaken or modified. These rules are effective on or after October 5, 2016, but allow a seven-year transition period to partners who have allocable shares of recourse partnership liability in excess of their tax basis. For additional information of the Temporary Regulations related to section 752 on BDGs, please see Tax News and Developments Client Alert New IRS Regulations End Bottom-Dollar Guarantees for Partnerships -- Action Advised distributed on October 20, 2016. The 704 & 752 Proposed Regulations The re-proposed sections 704 and 752 regulations (the "Re-proposed Regulations") create significant uncertainty in the use of guarantees to create recourse liabilities. In response to taxpayer comments the Re-proposed regulations eliminated the all-or-nothing approach of the six factors in the 2014 Proposed Regulations, but they essentially just repackaged these requirements in a facts and circumstances test, creating the same taxpayer concerns. The Reproposed Regulations include a list of seven non-exclusive factors which the IRS Baker & McKenzie 4 Tax News and Developments – Client Alert October 20, 2016 views as evidencing a plan to circumvent or avoid an obligation, and in truth, go further and remove all certainty in payment obligations. Five of these seven factors are identical to five of the requirements found in the 2014 Proposed Regulations. The other two factors combined are substantially the same as the sixth requirement in the 2014 Proposed Regulations. These factors are as follows: (1) The partner is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment; (2) The partner is not required to provide commercially reasonable documentation regarding the partner's financial condition; (3) The term of the payment obligation ends or is terminable by the partner before the partnership liability term; (4) There exists a plan where the primary obligor directly or indirectly holds money or other liquid assets that exceeds the reasonable foreseeable needs of the primary obligor; (5) The terms of the payment obligation do not permit the creditor to promptly pursue payment on default or there exist arrangements which otherwise work to delay payment; (6) In the case of a guarantee by a partner, the terms of the partnership liability do not differ with or without such guarantee; and (7) The creditor does not receive executed documents with respect to the partner's payment obligation. The problem with these factors is baked into the way they are drafted. Because of the negative phrasing, a plan to circumvent or avoid an obligation is almost presumed unless the partner takes steps to affirmatively refute the factors. The IRS makes this clear in the lone example provided: in the absence of evidence that the partner is subject to commercially reasonable contractual restrictions, for example, the IRS would take the position that no such restriction exists and would apply similar reasoning with respect to factors (2), (5), (6), and (7) to find a plan to circumvent or avoid the obligation in the absence countervailing evidence. Moreover, partners who make guarantees should be wary that the Re-proposed Regulations effectively eviscerate the presumption that a payment obligor will satisfy its obligation. This is especially true for partners who make guarantees through disregarded entities ("DRE"). Under the Re-proposed Regulations, if the ability of the payment obligor to pay is less than certain, the IRS may deem such fact as evidence of a plan to circumvent or avoid an obligation. Ultimately, the Reproposed Regulations would disregard any payment obligation, and allocate debt on a nonrecourse basis, if under the facts and circumstances, the obligor could not pay the full amount of the obligation were the obligation to come due. This anti-abuse rule would ostensibly displace the more straight-forward net value test in the existing regulations wherein payment obligations of a DRE owned by a partner would only be respected to the extent of the DRE's net value. The preamble to the Re-proposed Regulations makes clear, however, that the net value of the DRE would continue to be relevant under the facts and circumstances test of the anti-abuse rule, and indeed the example in the Reproposed Regulations illustrates that the net value test would survive within the anti-abuse rule. Moreover, this embedded net value factor no longer explicitly excludes individuals, thus, it appears that the anti-abuse rule would not so much as displace the net value test, but expand upon it and in the process vaporize the satisfaction presumption. Baker & McKenzie North America Tax Chicago +1 312 861 8000 Dallas +1 214 978 3000 Houston +1 713 427 5000 Miami +1 305 789 8900 New York +1 212 626 4100 Palo Alto +1 650 856 2400 San Francisco +1 415 576 3000 Toronto +1 416 863 1221 Washington, DC +1 202 452 7000 Baker & McKenzie 5 Tax News and Developments – Client Alert October 20, 2016 Effective Dates The 2016 Final Regulations generally apply to any transactions or transfers that occur on or after October 5, 2016. They also apply to liabilities that are incurred by a partnership, that a partnership takes property subject to, or that are assumed by the partnership on or after October 5, 2016. Liabilities that were incurred or assumed pursuant to a written binding contract in effect prior to October 5, 2016 are not subject to the 2016 Final Regulations. The Temporary Regulations are effective for any transaction to which all transfers occur on or after October 5, 2016. Finally, unless amended or rescinded, the Proposed Regulations would be effective once final. Advised Courses of Action Partnerships and partners are strongly advised to consider the impact of these changes made by the new regulations on existing partnerships, as well as future investment structures. With respect to currently proposed transactions, we advise taxpayers to examine the impact of the 2016 Final Regulations limitations to any transactions involving a partnership distribution as reimbursement of certain preformation capital expenditures. Moreover, if the proposed transactions involve a tiered partnership structure, taxpayers should consider the effect of the tracing rules in determining qualified liabilities and applying the RFPE Exception. For any transactions in which it is expected to create basis through the use of a guarantee to preempt "disguised sale" treatment, it is necessary to consider whether all transfers will occur on or after January 3, 2017. The Temporary Regulations do provide a transition rule, which allows a partner to continue to apply the existing regulations. However, partners should review existing and future guarantees or other similar arrangements in light of the Temporary Regulations. With respect to currently proposed partner payment obligations, taxpayers should: (1) review all payment obligations to see if any of the seven factors would be implicated; (2) at a minimum, ensure executed documentation of a payment obligation is delivered to creditor; and (3) maintain documentation of counter evidence for seven factors. Partners should be mindful that payment obligations may not be respected for debt allocation purposes if the obligor's ability to pay is less than certain for any reason, especially in the case where the payment obligor is an underfunded DRO. Tax News and Developments is a periodic publication of Baker & McKenzie’s North America Tax Practice Group. This Alert has been prepared for clients and professional associates of Baker & McKenzie. It is intended to provide only a summary of selected recent legal developments. For this reason, the information contained herein should not be relied upon as legal advice or formal opinion or regarded as a substitute for detailed advice in individual cases. The services of a competent professional adviser should be obtained in each instance so that the applicability of the relevant jurisdictions or other legal developments to the particular facts can be verified. To receive Tax News and Developments directly, please contact firstname.lastname@example.org. Your Trusted Tax Counsel® www.bakermckenzie.com/tax www.bakermckenzie.com For additional information please contact the authors of this Client Alert or any member of Baker & McKenzie’s North America Tax Practice Group. Richard M. Lipton +1 312 861-7590 email@example.com Steven R. Schneider +1 202 452 7006 firstname.lastname@example.org Sukbae David Gong +1 312 861 8600 David.Gong@bakermckenzie.com Keith Hagan +1 305 789-8988 email@example.com Michael D. 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