The principal effect of the rules would be to turn virtually any contribution of appreciated property by a US person to a section 721(c) partnership into a taxable gain recognition event.
On August 6, the US Treasury and US Internal Revenue Service (IRS) released Notice 2015-54, announcing their intention to promulgate regulations that, if adopted, will profoundly alter the taxation of domestic and foreign partnerships whose partners include a US partner and any related foreign partner (e.g., a controlled foreign corporation (CFC) of the US partner) if the US partner and any related partners hold—actually or by attribution—more than 50% of the interests in the partnership.
The yet-to-be-proposed rules will apply retroactively to virtually all contributions by a US partner to an affected partnership (defined as a “section 721(c) partnership”) on or after August 6, 2015. The principal effect of the rules is to turn virtually any contribution of appreciated property by a US person to a section 721(c) partnership into a taxable gain recognition event, either at the time of the contribution or at any subsequent time that strait-jacket conditions are violated. The rules appear to apply to deemed contributions resulting, for example, from so-called “technical terminations” of partnerships under section 708(b)(1)(B).
Because partnerships whose partners include both domestic and related foreign partners are components of many (perhaps most) multinational business structures, the potential impact of the proposed rules is broad and significant.
Below is a brief summary of the rules outlined in the Notice and our observations regarding their potential impact.
Prior to 1997, former sections 1491–94 imposed on US transferors a 35% excise tax on gain inherent in property transferred to a foreign partnership. In 1997, the US Congress repealed this excise tax, simultaneously giving Treasury and the IRS authority under section 721(c) to override, by regulation, the nonrecognition provision of section 721(a) in cases where appreciated property is transferred to a partnership if the gain would be includible in the income of a non-US person. Congress apparently believed that, in most cases, section 704(c) and the regulations thereunder would be sufficient to ensure that gain was allocated to the contributing partner, but wanted Treasury and the IRS to have the authority to require immediate recognition when section 704(c) failed to work as expected. In general, contributions of appreciated property to a partnership are tax free under section 721(a), but section 704(c) requires that the contributing partner be taxed on future partnership taxable income and gain attributable to untaxed (“built-in”) gain that existed at the time of contribution.
Treasury and the IRS understood correctly that shifts of built-in gain to related foreign partners might still occur where a technical limit on section 704(c) (called the “ceiling rule”) applies.
Treasury and the IRS appear to believe that the discrepancy between the treatment of transfers to partnerships and transfers to corporations is inappropriate. Notice 2015-54 therefore attempts to give taxpayers the same results regardless of whether they undertake an outbound transfer to a partnership or a corporation.
The mechanical rules of the Notice are fairly simple. In general, under section 721(a), neither the contributing partner nor the partnership is taxed on the contribution of appreciated property. Under the proposed rules, section 721(a) is called off and gain is recognized when a “US transferor” transfers appreciated property (other than cash equivalents and securities) from a “section 721(c) property” to a “section 721(c) partnership.” A de minimis rule also excludes items of tangible property with built-in gain that does not exceed $20,000. A “section 721(c) partnership” is defined as any partnership with a foreign partner who is related to the US transferor where the US transferor and “related persons” (as defined in section 267(b) and 707(b)(1)) own more than 50% of the capital, profits, deductions, or losses of the partnership after the transfer. However, a US transferor can claim the nonrecognition benefit of section 721(a) if it follows the “gain deferral method” set out in the Notice. The normal section 721(a) rules, however, will continue to apply even if no election to follow the gain deferral method is made if, during the US transferor’s taxable year, (1) the sum of the built-in gain with respect to all section 721(c) property contributed to the section 721(c) partnership in that year by the US transferor and all other US transferors that are related persons does not exceed $1 million and (2) the section 721(c) partnership is not applying the gain deferral method with respect to a prior contribution of section 721(c) property by the US transferor or another US transferor that is a related party.
The gain deferral method has five requirements:
- A section 721(c) partnership must adopt the remedial method with respect to all section 721(c) property.
- For any year in which there is remaining built-in gain with respect to section 721(c) property, a partnership must allocate all items of section 704(b) book income, gain, loss, and deduction with respect to the property in the same proportion. For example, if income with respect to an asset is allocated at 60/40, then gain, loss, and deduction with respect to that item must also be allocated at 60/40.
- A US transferor must immediately recognize built-in gain with respect to the property upon the occurrence of an “acceleration event,” which includes any transaction that either would reduce or could defer the built-in gain that a US transferor would recognize under the gain deferral method. This rule requires recognition of gain on the distribution to a non-contributing partner even if the property has been held by the partnership for more than seven years—a harsher consequence than is currently called for by sections 704(c)(1)(B) and 737 (the so-called “anti-mixing bowl rules”).
- The US transferor must comply with certain reporting requirements (the violation of which constitute an acceleration event).
- The gain deferral method must also be adopted for all section 721(c) property subsequently contributed to the partnership by the US transferor or any related US transferor until the earlier of the date that no built-in gain remains with respect to which the gain deferral method first applied, or 60 months after the initial contribution of section 721(c) property. The effective date of regulations promulgated under section 721(c) is August 6, 2015, the date of publication of the Notice (to the considerable misfortune of anyone who closed a transaction that morning). The rules also apply to transfers occurring before August 6 but that result from entity classification elections made on or after August 6.
The Notice also contains rules for tiered partnerships that generally treat upper-tier partnerships as owning directly interests in section 721(c) property held by lower-tier partnerships.
The second aspect of the Notice is that it expands the IRS’s authority to make adjustments under section 482. In particular, the Notice announces an intention to write regulations expanding the scope of certain rules under section 1.482-7 (dealing with cost sharing arrangements) to apply to transactions involving controlled partnerships. The new regulations will also contain rules allowing the IRS to make periodic adjustments to partnership items when there is a significant divergence of actual returns from the taxpayer’s projected returns. The periodic adjustment rules appear to represent a significant expansion of the IRS’s authority to reallocate partnership items among partners.
Finally, to ensure that the IRS can extract its full “pound of flesh” from partnerships that perform unexpectedly well, the Notice announces an intention to promulgate regulations requiring that taxpayers who wish to avail themselves of section 721(a) for contributions to section 721(c) partnerships extend the statute of limitations with respect to all section 721(c) property for a full eight years. This requirement will not apply to contributions that occur before the publication of regulations.
Despite the requirement that all allocations be in the same proportion for each asset, it appears that partners can, with careful drafting, still use different classes of interests, even in section 721(c) partnerships. For example, a preferred interest that allocates bottom-line income appears to comport with the rules.
The new rules appear to apply to both actual and deemed contributions of property. As a result, a partnership formed many years ago that would run afoul of even one of the new rules could trigger gain recognition to US partners if it undergoes a technical termination under section 708(b)(1)(B) (for example, if its majority partner elects a new entity classification). The Notice only denies nonrecognition treatment under section 721(a) for US partners, so other transactions, such as contributions by foreign partners, are generally unaffected.
Contributions of non-depreciable, non-amortizable property are affected by the rule, in that taxpayers are still required to elect the remedial method (and follow the other requirements of the Notice). However, if such property is not sold, the effect of the Notice in these cases should not be material.