International Joint Venture Issues - Practising Law Institute

Practising Law Institute

Tax Planning For Domestic & Foreign

Partnerships, LLCs, Joint Ventures & Other

Strategic Alliances 2016

International Joint Venture Issues

Paul Oosterhuis

Skadden, Arps, Slate,

Meagher & Flom LLP

Chris Trump

Deloitte Tax LLP

Jason T. Smyczek

Senior Technical Reviewer, Branch 4,

Associate Chief Counsel (International), IRS

FORMATION AND NOTICE

2015-54

3

Partnership Contributions In General

Section 721(a) allows for the tax deferred transfer of built in gain (or loss) property by a partner‏

to a partnership, without analog to the control requirements imposed on transfers to corporations

under section 351.

• In‏general,‏section‏721‏operates‏without‏regard‏to‏transferor’s‏specific‏economic‏interest‏in‏

contributed property, thus allowing for mixing bowl effect within partnership.

Section 704(c) requires any built in gains and losses existing at the time of the transfer, when‏

recognized, to be allocated to the transferor.

• However, these requirements may be avoided in part by application of the ceiling rule, which

limits such allocations to gain and loss items from the property itself. Treas. Reg. §1.704-

3(b)(1).

• Since‏,1997‏section721‏(c)‏has‏allowed‏the‏IRS‏by‏regulation‏to‏“turn-off”‏section721‏(a)‏if‏gain‏

when recognized would be included in the income of a non-U.S. person.

• Notice 2015-54, released on August 6, 2015, announced the intent to issue such

regulations and provided detailed rules with immediate effect.

− Notice 2015-54, although apparently targeting transfers of intellectual property, applies

regardless of the nature of the property transferred and irrespective of whether the income

from the property is subject to immediate U.S. taxation under subpart F or as effectively

connected income.

4

Pre-Notice Analysis

Facts‏

• USP, a U.S. corporation, wholly owns FS, a foreign

corporation. USP and FS contribute property to PRS, a

partnership.

• USP contributes Asset A, with a large amount of built-in

gain. FS contributes Asset B.

Pre-Notice Analysis‏

• The contribution of Asset A does not result in gain

recognition under section 721(a).

• PRS could use one of three methods (i.e., traditional

method, traditional method with curative allocations, or

remedial method), subject to certain anti-abuse rules, to

account for the built-in gain of Asset A in allocating items

of income, deduction, gain, or loss to its partners.

• Regardless of the form of consideration received (except

in the case of certain partnership interests), the transferor

is effectively selling a portion of Asset A.

• Following the contribution to the partnership, the

contributing partner recognizes income attributable to its

partnership interest.

• The timing of recognition of the built-in gain in the asset

depends on the section 704(c) method chosen.

Asset B

FS

PRS

USP

Asset A

Value – $100M

Basis – $0

5

Notice 2015-54 Notice 2015-54, issued on August 6, 2015, announces the intent to issue regulations‏under section 721(c) to ensure that, when a U.S. person transfers certain property to a partnership that has foreign partners related to the transferor, income or gain attributable to the property will be taken into account by the transferor either immediately or periodically (through the remedial section 704(c) method).

• The new regulations will have two main features:

− Significant new restrictions will apply if the U.S. partner and related foreign person

together own more than 50 percent of the interests in partnership capital, profits, deductions or losses, and the U.S. partner contributes built-in gain property to the partnership.

− Immediate gain recognition will be required under section 721(c) on the contribution‏unless‏the‏partnership‏adopts‏the‏“Gain‏Deferral‏Method.”‏

Section 482 regulations will be issued to specify transfer pricing methods applicable to‏controlled transactions involving related-party partnerships. These specified methods, which may apply to partnership contributions, partnership distributions, and partnership allocations, will mirror the methods currently prescribed for cost-sharing arrangements and‏will‏include‏a‏‘periodic‏trigger’‏feature‏similar‏to‏the‏cost-sharing periodic trigger.

6

Gain Deferral Method

The regulations will include an exception to the application of section 721(c)‏

(the‏“Gain‏Deferral‏Method”)‏which‏may‏be‏used‏to‏the‏extent‏five‏requirements‏

are met.

• First. The Section 721(c) Partnership adopts the remedial allocation method

described in Treas. Reg. § 1.704-3(d) for Built-in Gain with respect to all

Section 721(c) Property contributed to the Section 721(c) Partnership

pursuant to the same plan by a U.S. Transferor and all other U.S. Transferors

that are Related Persons.

7

• Second. During any taxable year in which there is remaining Built-In Gain with respect to an item of Section 721(c) Property, the Section 721(c) Partnership allocates all items of section 704(b) income, gain, loss, and deduction with respect to that Section 721(c) Property in the same proportion;

• Third. Reporting requirements described in Section 4.06 of the Notice are satisfied.

• Fourth. U.S. Transferor recognizes Built-in Gain with respect to any item of Section 721(c) Property upon an Acceleration Event described in Section 4.05 of the Notice; and

• Fifth. The Gain Deferral Method is adopted for all Section 721(c) Property subsequently contributed by the U.S. Transferor and related U.S. Transferors until the earlier of:

− the date when no Built-in Gain remains with respect to any Section 721(c) Property to which the Gain Deferral Method first applied; or

− 60 months after the initial contribution of Section 721(c) Property to which the Gain Deferral Method first applied.

Gain Deferral Method

8

Effective Dates

The regulations described in the Notice with respect to the application of section‏

721(c) will apply to transfers occurring on or after August 6, 2015, and to transfers

occurring before August 6, 2015, resulting from entity classification elections made

under Treas. Reg. § 301.7701-3 that are filed on or after August 6, 2015, and that

are effective on or before August 6, 2015.

The section 482 and section 6662 regulations described in the Notice will apply to‏

transactions occurring on or after the date regulations are published.

8

9

Notice 2015-54: Example 1

USP, a domestic corporation, wholly owns‏

FS, a foreign corporation

USP and FS form a new partnership, PRS‏

FS contributes cash of $1.5M‏

:USP contributes‏

• a patent with FMV = $1.2M,

basis = $0

• a security with FMV = $100k, basis =

$20K

• a machine with FMV = $200K,

basis = $600K

$1.5M

cash

FS (Foreign)

USP (U.S.)

PRS

$1.5M:

1. Patent

2. Security

3. Machine

10

Notice 2015-54: Example 1 (cont’d)

Analysis

The Patent is Section 721(c) Property because‏

it has Built-in Gain (FMV = $1.2M; AB = $0).

The security has Built-in Gain, but is Excluded‏

Property.

The machine has built-in loss; therefore, it is‏

not Section 721(c) Property.

.FS is a Related Foreign Person to USP‏

USP and FS collectively own more than 50% of‏

the interests in the capital, profits, deductions

or losses of PRS; therefore, PRS is a Section

721(c) Partnership.

‏USP’s‏to‏apply‏not‏does‏(a)721‏Section‏

contribution of the patent to PRS unless the

Gain Deferral Method is applied.

$1.5M:

1. Patent

2. Security

3. Machine

FS (Foreign)

USP (U.S.)

PRS

$1.5M Cash

11

Notice 2015-54: Example 2

USP, a domestic corporation, wholly owns

FS, a foreign corporation.

USP and FS own all of the interests in

PRS, which was formed prior to the

effective date of Notice 2015-54.

USP’s‏management‏concludes‏that‏USP

should not hold the PRS interest directly

and causes USP to contribute the PRS

interest to U.S. Sub in exchange for U.S.

Sub Stock.

U.S. Sub (U.S.)

USP (U.S.)

FS (Foreign)

USP (U.S.)

U.S. Sub (U.S.)

FS (Foreign)

PRS (U.S.)

PRS (U.S)

.

Stock

PRS

Interest

40%

60%

40% 60%

12

Notice 2015-54: Example 2 (Cont’d)

PRS terminates for tax purposes under

section 708(b)(1)(B).

Deemed Transactions:

PRS contributes its assets to new

PRS in exchange for New PRS

interests‏and‏New‏PRS’‏assumption‏

of‏PRS’‏liabilities.

New PRS liquidates, distributing New

PRS interests to FS and to U.S. Sub.

Notice 2015-54 Applies?

New PRS Interest

USP

(U.S.)

FS

(Foreign)

PRS

(U.S.)

U.S. Sub

(U.S.)

Assets

New

PRS

New PRS

Interest

Deemed

Transactions

New PRS Interests

13

Observations / Open Questions

Third Party JVs - Although the Notice appears to be targeted at

partnerships between related taxpayers, the rules are broad enough to

affect some third-party joint ventures.

Deemed Partnerships - It is not always clear whether the economic‏

relationship between taxpayers constitutes a partnership for U.S. federal

income‏tax‏purposes‏or‏whether‏a‏particular‏taxpayer’s‏interest‏in‏a‏

partnership is debt or equity. With the requirement of immediate gain

recognition turning on whether a relationship is a tax partnership and who

the partners are, the stakes surrounding these determinations have been

raised.

14


Technical Terminations - Taxpayers will need to carefully monitor‏

transfers of partnership interests that could result in a technical

termination of a partnership in existence before the date of the Notice,

which could cause a deemed contribution to a new partnership of

built-in gain assets contributed to the old partnership prior to the date

of the Notice.

15


– Proportionate Allocations Requirement‏

• The proportionate allocation rule prohibits special allocations of particular

section 704(b) items (income, gain, loss, deduction) with respect to an

item of Section 721(c) Property.

• The‏reference‏to‏‘an‏item’‏of‏Section721‏(c)‏Property‏indicates‏that‏the‏

determination of whether all items with the respect to a Section 721(c)

Property are made on a property-by-property basis.

• Deductions attributable to built-in gain property (e.g., IP development

costs incurred as part of a cost share agreement) cannot be specially

allocated to USP.

• In addition, regulatory allocations and allocations of foreign tax credits

required under the section 704(b) regulations may require certain items

to be shared in different proportions. Presumably regulations will

address whether such allocations violate the proportionate allocation

rule.

16


The concept of Acceleration Events set forth in the notice is

very broad.

• Because the regulations appear to measure built-in gain (and reductions in built-

in gain) only at the level of the Section 721(c) Partnership, a distribution of

Section 721(c) Property to the U.S. Transferor that contributed such property

could be an Acceleration Event, even though the built-in gain is preserved in the

hands of the U.S. Transferor.

• Certain transactions are excepted:

− Contribution of Section 721(c) Property by a Section 721(c) Partnership to a

domestic corporation in a transaction described in section 351(a).

− Contribution of an interest in a Section 721(c) Partnership to a domestic

corporation in a transaction described in section 351(a) or section 381(a);

− Contribution of Section 721(c) Property by a Section 721(c) Partnership to a

foreign corporation in a transaction described in section 351(a), provided the

property is treated as being transferred by a U.S. person (other than a

domestic partnership) under section 367.

17

Acceleration Rule

Facts‏

• USP, a U.S. corporation, wholly owns FS, a

foreign corporation. USP and FS are partners in

PRS, a partnership.

• In Year 1, USP contributes Asset A to PRS.

• In Year 9, when Asset A has remaining built-in

gain, PRS distributes Asset A to FS.

Analysis‏

• Section 704(c)(1)(B) (which requires gain

recognition in certain circumstances) should not

apply because PRS distributed Asset A after 7

years from the date it was contributed to PRS.

• However, because USP will not recognize any

remaining gain with respect to Asset A after the

distribution, the distribution is an Acceleration

Event.

• Accordingly, USP is required to recognize any

remaining gain of Asset A.

Asset A

Value – $100M

Basis – $0

FS

USP

PRS

PARTNERSHIPS AND

CONTROLLED FOREIGN

CORPORATIONS

19

CFCs – Income Inclusion Rule

If‏a‏foreign‏corporation‏is‏a‏controlled‏foreign‏corporation‏(“CFC”)‏for‏an‏

uninterrupted period of 30 days or more during any taxable year, each person

who is a U.S. shareholder, as defined in section 951(b), and who

owns…stock‏in‏such‏corporation‏on‏the‏last‏day‏in‏such‏year‏in‏which‏the‏

corporation‏is‏a‏CFC,‏must‏include‏in‏its‏gross‏income‏the‏shareholder’s‏pro‏

rata‏share‏of‏the‏CFC’s‏“Subpart‏F income”

A U.S.‏shareholder‏is‏a‏“U.S.‏person,”‏as‏defined‏in‏section 7701(a)(30), that

owns, (within the meaning of section 958(a) or (b)), 10 percent or more of the

voting stock of a foreign corporation

Under section 7701(a)(30),‏a‏“U.S.‏person”‏includes‏residents‏or‏citizens‏

of the U.S. or domestic partnerships or corporations. USCo, a domestic

corporation, is a U.S. person

20

U.S. vs. Foreign Partnership

FP

Pship

(US)

Foreign

Persons

FP

Pship

(X)

Foreign

Persons or

<10% US

Persons

FP is a CFC FP is a NOT a CFC

21

Foreign Personal Holding

Includes:

Dividends

Interest

Rents

Royalties

Excess of gain over loss from:

o Sale of stock,

o Debt instruments,

o Less-than-25 percent partnership interests,

o Property that does not give rise to any income

Exceptions:

Look through from related CFC (section 954(c)(6))

Same country exception (dividend or interest from related CFC organized in same country as

recipient and meeting certain other tests) (section 954(c)(3)(A)(i))

Qualified "banking or financing income" of an eligible CFC (section 954(h))

Active rents and royalties from unrelated persons (section 954(c)(2)(A))

Look-through for sale of partnership interest where CFC owns at least 25 percent of the partnership

(section 954(c)(4))

22

Foreign Base Company Sales Income

FBCSI Includes:

Subject to various exceptions, Foreign Base Company Sales Income under section 954(d) is:

o Income derived in connection with the purchase of personal property from a related person and

its sale to any person;

o Income derived from the sale of personal property to any person on behalf of a related person;

o Income derived from the purchase of personal property from any person and its sale to a

related person; OR

o Income derived from the purchase of personal property from any person on behalf of a related

person.

Sales income will not constitute FBCSI if:

The property is manufactured (by anyone) in the CFC's country of organization, OR

The property is sold for use in the CFC's country of organization, OR

The property is manufactured or produced by the CFC.

EVEN if the property is purchased from, or sold to, a related person.

23

Brown Group Regulations

Generally, the rules of Subpart F apply at the CFC partner level as if the

income were earned directly. Treas. Reg. § 1.952-1(g)

Country of incorporation determinations based on country of CFC

incorporation

Related party determinations based on CFC/partner relationship to

other parties

Activities and property to be taken into account at partner level for

exceptions generally consider only the activities and property of the

partnership

24

Application to Subpart F Sales Income

Subpart F Sales Income Generally Results to CFC Under

Reg. § 1.954-3 if:

Product is purchased from or sold to a related party of

CFC;

Product is not manufactured by CFC (or by third party

in country of CFC incorporation); and

Product is sold for use or consumption outside country

of CFC incorporation.

Application to FJV Under Reg. § 1.954-3(a)(6):

Sales (or purchases) by FJV are determined to be

to a related person based on CFC, not FJV,

relationship

FJV treated as manufacturer based only on FJV

activities; “separate” activities of Foreign Co and/or

CFC are not taken into account.

FJV may be manufacturer as principal in contract

manufacturing arrangement if FJV employees make a

substantial contribution to the manufacture of the

property

Foreign Co

FJV

US Co

CFC

Mfg. Ops

Sales of

mfg. goods

>50%

25

Partnership Payment: §954(c)(6) and (c)(3)

Interest, rents, or

royalties

Foreign Co

FJV

US Co

CFC1 CFC 2

Section 954(c)(6):

• Interest, rents or royalties treated as paid by CFC1 and

Foreign Co. for section 954(c)(6) purposes.

• Therefore, look through rule of section 954(c)(6) is again

applicable to payments made to CFC2.

Section 954(c)(3):

• Same Country Exception of section 954(c)(3) could also

apply to CFC2, to the extent the payments are attributable to

CFC1, and assuming the substantial assets test is met.

• How do we treat the interest in FJV for purposes of the

substantial assets test?

o Treas. Reg. § 1.954-2(b)(4)(x) allows a CFC to look

through stock of a subsidiary in determining whether a

CFC’s‏assets‏are‏located‏in‏its‏country‏of‏organization.

o What about partnership interests?

o Note section 1297(c).

>50%

26

Partnership Income: §954(c)(6) and (c)(3)

Dividends,

interest, rents

or royalties

Foreign Co

FJV

US Co

CFC1 CFC 2

:Section 954(c)(6)‏

• Payments received by FJV are treated as

received or accrued by CFC1 and Foreign Co

for purposes of section 954(c)(6).

• Therefore, look through rule of section

954(c)(6) is applicable to CFC1.

:Section 954(c)(3)‏

• Same Country Exception of section 954(c)(3)

could also apply to CFC1, assuming other

requirements are met (including the substantial

assets test).

>50%

27

Section 956 – In General

Inclusions under section 951(a)(1)(B)‏

• Lesser of:

o CFC’s‏average‏adjusted‏basis‏in‏U.S.‏property‏(average‏of‏the‏4‏quarter-ends) less prior section 956 PTI, or

o CFC's‏"applicable‏earnings”‏(current‏and‏accumulated‏earnings‏less‏current‏year‏dividends‏and‏less‏prior‏

section 956 PTI)

:Section 956 defines U.S. Property to include‏

• tangible property located in the United States;

• stock of its U.S. shareholder or a domestic corporation which is 25 percent or more owned or treated

as‏being‏owned‏by‏the‏CFC’s‏U.S.‏shareholder‏after‏the‏acquisition;

• an obligation of a United States person; or

• any right to the use in the United States of—

o a patent or copyright,

o an invention, model, or design (whether or not patented),

o a secret formula or process, or

o any other similar right,

which is acquired or developed by the controlled foreign corporation for use in the United States

28

Revenue Ruling 90-112

:Facts‏

• S, a CFC, owned a 25 percent interest in PRS, a

partnership

• The remaining 75 percent of PRS was owned by

unrelated parties

• PRS’‏assets‏included‏U.S.‏real‏estate which

constitutes U.S. property under section 956

:Ruling‏

• The U.S. real estate owned by PRS is U.S.

property treated as owned by S for purposes of

section 956

• The amount which constitutes U.S. property is

calculated based on the adjusted basis of the

U.S. property in the hands of the partnership,

limited by the adjusted basis that S has in its

PRS partnership interest

U.S. Real

Estate

S

(Foreign)

P

(U.S.)

PRS

Unrelated

(Foreign)

25% 75%

FMV = 200

Basis = 80

FMV = 50

Basis = 10

29

Treas. Reg. § 1.956-2(a)(3)

Treas. Reg. § 1.956-2(a)(3) provides that if a CFC is‏

a partner in a partnership that owns U.S. property,

the‏CFC‏will‏be‏treated‏as‏“holding‏an‏interest‏in‏the‏

property equal to its interest in the partnership and

such interest will be treated as an interest in United

States‏property”

-Thus, Rev. Rul. 90-112 and Treas. Reg. § 1.956‏

2(a)(3) generally adopt aggregate type principles for

section 956

See also Treas. Reg. § 1.956-3T(b)(2)(ii)(A)‏

CFC1

USP

U.S.

Parent

CFC2

U.S.

Property

30

Application of Section 956

Loan to Foreign Partnership Background

‏and‏(a)956‏section‏of‏purposes‏for‏property‏.U.S‏is‏”person‏.U.S‏a‏of‏obligation“‏An‏

a U.S. person includes domestic partnerships.

• Thus, a loan from a CFC to a domestic partnership results in the CFC holding

an obligation of a U.S. person, and therefore U.S. property.

• This rule treats the partnership as an entity for this purpose rather than an

aggregate of its partners.

,In the preamble to proposed regulations under section 954(i) published on Jan. 17‏

2006, the IRS requested comments whether a loan from a CFC to a foreign

partnership that has one or more U.S. partners results in the CFC holding an

obligation of a U.S. person for purposes of section 956.

31

Application of Section 956

Loan to Foreign Partnership Commentary

IRS requested comments on whether CFC should‏

be treated as making a loan to USP, triggering a

section 956 inclusion.

The NYSBA issued comments in which it argued‏

that because the Subpart F regime treats a

domestic partnership as a U.S. person, Subpart F

similarly should treat a foreign partnership as a

separate‏entity‏that’s‏not‏a‏U.S.‏person.‏Thus,‏the‏

CFC generally should not be treated as holding

an obligation of a U.S. person for purposes of

section 956.

NYSBA acknowledged, however, that to the‏

extent FP invested the proceeds in U.S. property,

including any loan of the proceeds to USP, or

distributed the proceeds to USP, and one of the

principal purposes of the transaction was the

avoidance of section 956, it would be appropriate

for the IRS to treat CFC as holding U.S. property.

USP

(U.S.)

USS CFC

FP

(For)

32

Application of Sec. 956 to Partnerships

Temporary and Proposed Regulations

On September 2, 2015, Treasury released temporary and proposed regulations‏

addressing application of section 956 to partnership transactions.

The temporary regulations address application of the anti-abuse rule to partnership‏

entities and partnership distributions funded by CFCs.

• The temporary regulations are effective with respect to taxable years of CFCs

ending on or after September 2, 2015.

• The temporary regulations expire in three years if not finalized under the sunset

provisions.

.The proposed regulations address, in part, whether the obligations of a non-U.S‏

partnership will be treated as U.S. property for purposes of section 956.

• The proposed regulations are proposed to be effective with respect to taxable

years of CFCs ending on or after the date final regulations are published, and

taxable years of U.S. shareholders in which or with respect to which such taxable

years end.

33

Application of Sec. 956 to Partnership Transactions

Temporary Regulations

The temporary regulations address Treasury and IRS concerns that taxpayers may‏be using partnerships to structure transactions that are similar to transactions addressed by Treas. Reg. § 1.956-1T(b)(4)

• Treas. Reg. § 1.956-1T(b)(4) is currently applicable to transactions that involve foreign corporations that are controlled by a CFC and requires the IRS to exercise its discretion

• Treasury and IRS were concerned with the following transactions:

− CFC funded loans

◦ CFC contributes cash to partnership

◦ Partnership loans cash to U.S. shareholder of the CFC

◦ Taxpayer position: CFC is treated as holding an interest in the obligation only to the extent‏of‏the‏CFC’s‏interest‏in‏the‏partnership

− CFC funded distributions

◦ CFC lends (or guarantees loan) to foreign partnership

◦ Foreign partnership distributes proceeds to U.S. partner who is related to CFC

◦ Taxpayer position: Section 956 does not apply

34



Treas. Reg. § 1.956-1T(b)(4) expanded to include transactions involving‏partnerships that are controlled by the CFC

• U.S. property held indirectly by a CFC includes –

− “Property‏acquired‏by‏a‏partnership‏that‏is‏controlled‏by‏the‏controlled‏foreign‏corporation if the property would be United States property if held directly by the controlled foreign corporation, and a principal purpose of creating, organizing, or funding by any means (including through capital contributions or debt) the partnership is to avoid the application of section 956 with respect to the‏controlled‏foreign‏corporation.”

− Control –

◦ CFC controls the foreign partnership if the CFC and the partnership are related within the meaning of 707(b)

◦ For purposes of determining whether two corporations are members of the same “controlled‏group”,‏section267‏(c)‏principles‏apply

Rule is self-executing (both with respect to transactions involving corporations and‏transactions involving partnerships)

35

FS1 has substantial e&p‏

FS1 contributes $600 to FP in‏exchange for a 60% interest

USP contributes Non-US real property‏valued at $400 in exchange for a 40% interest

FP lends $100 to USP‏

• FS1 is treated as holding U.S. property of $60 pursuant to Treas. Reg. 1.956-2(a)(3).

If a principal purpose of organizing FP‏is to avoid section 956 with respect to FS1, FS1 is treated as holding U.S. property of $100

• $60 under Treas. Reg. § 1.956-2(a)(3)

• $40 under Temp. Treas. Reg. § 1.956-2(b)(4)(i)(C) and (b)(4)(iii)

USP

(U.S.)

FS1

FP

(For)

40%

Non-US RP

$400 value

60%

$100 Loan



36

General Rule

An obligation of a foreign partnership held (or treated as held) by a CFC is

treated as a separate obligation of a partner in the partnership if –

• The foreign partnership distributes an amount of money or property to the

partner

• The foreign partnership would not have made the distribution but for a funding

of the partnership through the obligation

• The partner is related to the CFC within the meaning of section 954(d)(3)

Amount of obligation

The lesser of (a) the amount of the partnership distribution that would not

have been made but for such funding or (b) the amount of the obligation of

the foreign partnership that is held (or treated as held) by the CFC


Temporary Regulations – Partnership Distributions

37

USP wholly owns FS, a CFC‏

USP owns a 70% interest in FP‏

UTP, a domestic corporation, owns the‏remaining 30% interest in FP

FP borrows $100 from FS and‏distributes $80 to USP

FP would not have made the‏distribution to USP but for the funding by FS

A portion of the obligation that FS holds‏is treated as an obligation of USP

The amount treated as an obligation of‏USP is the lesser of $80 (the amount of the distribution) or $100 (the amount of the obligation that is held by the CFC)

UTP (U.S.) FS

FP

(For)

30%

70%

$100 Loan

USP

(U.S.)

$80

Distribution



38

Treasury and IRS determined that failing to treat an obligation of a foreign‏

partnership as an obligation of its partners could allow deferral of U.S. taxation of

CFC earnings and profits in a manner inconsistent with the purposes of section

956

:Areas of concern‏

• Potential ability of U.S. shareholder to access deferred CFC earnings loaned to

a foreign partnership in which the U.S. shareholder is a partner without those

earnings becoming subject to U.S. tax by causing the partnership to make a

distribution

Proposed regulations treat an obligation of a foreign partnership as an obligation‏

of its partners, subject to an exception for obligations of foreign partnerships in

which neither the lending CFC nor any person related to the lending CFC is a

partner


Proposed Regulations § 1.956-4

39


Proposed Regulations § 1.956-4(b)

A partner in a partnership is treated as holding its attributable share of any‏

property held by the partnership (including partnership obligations)

‏liquidation‏partner’s‏the‏with‏accordance‏in‏determined‏is‏share‏Attributable‏

value percentage:

• Liquidation Value - The amount of cash the partner would receive if

immediately after the occurrence of the most recent revaluation event or, if

none, immediately after the formation of the partnership, the partnership sold

all of its assets for cash equal to the fair market value of such assets, satisfied

its liabilities (other than certain contingent liabilities), paid an unrelated third

party to assume its contingent liabilities in a fully taxable transaction, and then

liquidated.

• Liquidation Percentage – The‏ratio‏of‏the‏liquidation‏value‏of‏the‏partner’s‏

interest in the partnership divided by the aggregate liquidation value of all of

the‏partners’‏interests‏in‏the‏partnership.

− Special allocations taken into account if the special allocation does not have

a principal purpose of avoiding section 956.

40



USP owns 100% of FS, a foreign corporation that is a‏

CFC

FS owns an interest in FP, a foreign partnership; an‏

unrelated third party owns the rest of the interest in FP

FP owns non-depreciable property with a basis of‏

$100 – the property would be U.S. property if held by

FS directly

‏value‏liquidation‏’FS‏,quarter‏the‏of‏close‏the‏At‏

percentage is 25%

FS is treated as holding its attributable share of the‏

property with an adjusted basis equal to its attributable

share‏of‏FP’s‏adjusted‏basis‏in‏the‏property

• FS liquidation value percentage is 25%

• FS‏attributable‏share‏of‏FP’s‏adjusted‏basis‏is$25‏

• FS is treated as holding US property with an

adjusted basis of $25

FS

FP

(For)

Non-depreciable property

A/B = $100

USP

(U.S.)

100%

UTP

Non-U.S.

41

USP owns 100% of FS, a foreign corporation that is a CFC‏

FS owns an interest in FP, a foreign partnership; an‏

unrelated third party owns the rest of the interest in FP

– FP owns non-depreciable property with a basis of $100‏

the property would be U.S. property if held by FS directly

Income with respect to U.S. property is specially allocated‏

to FS

• The special allocation does not have a principal purpose

of avoiding section 956

‏its‏with‏accordance‏in‏determined‏is‏share‏attributable‏FS’s‏

special allocation

• FS’s‏special‏allocation‏percentage‏for‏U.S.‏property‏is‏

‏in‏basis‏adjusted‏FP’s‏of‏share‏attributable‏its‏and‏80%

the property is $80

• FS is treated as holding U.S. property with a basis of $80

FS

FP

(For)

Non-depreciable property

A/B = $100

USP

(U.S.)

100%

UTP

Non-U.S.



42


FS owns an interest in FP, a foreign partnership; USP owns the‏

rest of the interest in FP

FP owns property with an adjusted basis of $100; the property‏

would be U.S. property if held by FS directly

FP is anticipated to appreciate in value, but to generate‏

relatively little income

The partnership agreement specially allocates 80% of the‏

income with respect to the property to USP and 80% of the

gain with respect to the disposition of the property to FS.

• The allocation does not have a principal purpose of avoiding

the purposes of section 956

‏accordance‏in‏determined‏are‏shares‏attributable‏’partners‏The‏

with the special allocation

• FS’s‏attributable‏share‏of‏FP’s‏property‏is‏80%‏and‏its‏

attributable‏share‏of‏FP’s‏adjusted‏basis‏in‏the‏property‏is‏

$80

• FS is treated has holding U.S. property with a basis of $80

FS

FP

(For)

100%

USP

(U.S.)

Property

A/B = $100



43

Obligations of a Foreign Partnership

Proposed Regulations § 1.956-4(c)

An obligation of a foreign partnership is treated as a separate obligation of each of‏

the‏partners‏in‏the‏partnership‏to‏the‏extent‏of‏each‏partner’s‏share‏of‏the‏

obligation

in accordance with the‏determined‏obligation‏partnership‏of‏share‏Partner’s‏

partner’s interest in partnership profits

• Preamble notes that the approach is consistent with the observation that, to the

extent the proceeds are used by the partnership to invest in profit-generating

activities, partners (including service partners) will benefit from the obligation to

the extent of their interest in partnership profits

• Share of‏obligation‏determined‏as‏of‏the‏close‏of‏each‏quarter‏of‏the‏CFC’s‏

taxable year

Exceptions‏

• Foregoing rules do not apply if neither the CFC, nor any person related to the

CFC, is a partner in the partnership

44

Application of Sec. 956 to Partnership Obligations


USP owns 100% of FS, a foreign corporation‏

that is a CFC

USP also owns a 90% interest in the‏

partnership profits of FP

UTP X owns a 10% interest in the profits of FP‏

FP borrows $100 from FS; FS basis in the‏

obligation is $100

The $100 obligation is treated as the obligation‏

of USP and UTP X to the extent of their

respective interests in partnership profits

• USP’s‏share‏of‏the‏obligation‏is‏$90‏because‏

its share of profits is 90%

• $90 of the obligation held by FS is treated as

an obligation of USP and is US property

• On the date the loan is made, FS is treated

as holding $90 of U.S. property

FS

FP

(For)

90% Profits

USP

(U.S.)

$100 Loan

UTP X

Non-U.S.

10% Profits

100%

45



USP owns 40% of FS, a foreign corporation that‏

is a CFC

Unrelated third party Z, a U.S. person, owns the‏

remaining 60% of FS

USP also owns a 90% interest in the partnership‏

profits of FP

UTP X owns a 10% interest in the profits of FP‏

FP borrows $100 from FS; FS basis in the‏

obligation is $100

Unrelated lender exception applies‏

• Neither FS nor any person related to FS

(within the meaning of section 954(d)(3)) is a

partner in the partnership

• The obligation is treated as an obligation of a

foreign partnership, not of a U.S. person

• FS is not treated as holding U.S. property

FS

FP

(For)

90% Profits

USP

(U.S.)

$100 Loan

UTP Z

(U.S.)

10% Profits

60%

UTP X

Non-U.S.

40%

46




USP also owns a 60% interest in the partnership profits of‏

FP

FS has a 30% interest in the partnership profits of FP‏

USC, a U.S. corporation, has a 10% interest in the profits of‏

FP

FP borrows $100 from an unrelated person‏

FS guarantees the obligation‏

The $100 obligation is treated as the obligation of USP, FS‏

and USC to the extent of their respective interests in

partnership profits

• Unrelated lender exception does not apply‏USP’s‏share

of the obligation is $60 because its share of profits is

‏its‏because‏$30‏is‏obligation‏the‏of‏share‏FS’s‏;60%

share of profits is 30%; USC share of the obligation is

$10 because its share of profits is 10%

• FS, as guarantor, is treated as holding the obligations of

USP and USC that it guarantee

FS

FP

(For)

30% Profits

USP

(U.S.)

$100 Loan UTP Z

10% Profits

USC

(U.S.)

60% Profits Guarantees

FP debt

47



USP owns 100% of FS, a foreign corporation that is a‏CFC

USP also owns a 70% interest in the partnership profits‏of FP

UTP X has a 30% interest in the partnership profits of‏FP

FP borrows $100 from FS and makes a distribution of‏$80 to USP

• FP would not have made the distribution to USP but for the funding of FP by FS

Unrelated lender exception does not apply with respect‏to USP

An obligation of USP held by FS would be U.S. property‏

$70‏is‏obligation‏the‏of‏share‏attributable‏USP’s‏

‏its‏(i)‏of‏greater‏the‏is‏obligation‏the‏of‏share‏USP’s‏share of the obligation ($70), or (ii) the lesser of (a) the distribution ($80), or (b) the amount of the obligation ($100).

• Thus, on the date of the loan, FS is treated as holding US property of $80

FS

FP (For)

30% Profits

USP (U.S.)

$80 Distribution

UTP X (U.S.)

70% Profits $100 Loan

48


Proposed Regulations

Pledges and Guarantees‏

• Current Rule

− An obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor is

considered for purposes of section 956 to be U.S. property held by the CFC

• Proposed Regulations

− Any obligation of a U.S. person with respect to which a CFC or a partnership is a pledgor

or guarantor (directly or indirectly) is considered for purposes of section 956 to be U.S.

property held by the CFC, or the partnership, as the case may be.

◦ CFC that is a partner in the pledgor partnership is not itself treated as a pledgor solely as a

result of its ownership of an interest in the partnership

◦ How does one treat the pledge of a partnership interest by a U.S. person that has a related CFC partner?

− Existing Pledges and Guarantees

◦ The proposed regulations are proposed to be effective with respect to pledges and guarantees

entered into on or after the date published in the federal register

◦ A pledgor or guarantor is treated as entering into a pledge or guarantee when there is a

significant modification of an obligation with respect to which it is a pledgor or guarantor on or

after the date the regulations are published in the federal register

49

Application of Sec. 956 to Partnerships

Proposed Regulations – Pledges and Guarantees

USP owns 90% of FP, a foreign‏partnership, and 70% of FS, a foreign corporation that is a CFC

profits‏FP’s‏in‏interest‏90%‏a‏has‏USP‏

Z, an unrelated third party loans $100‏to FP

FS pledges its assets as security for the‏loan

Under Prop. Treas. Reg. § 1.956-4(c)‏‏is‏Z‏UTP‏to‏obligation‏$100‏FP’s‏of‏$90treated as an obligation of USP for purposes of section 956

-Under Prop. Treas. Reg. § 1.956‏2(c)(1), FS is considered to hold an obligation of USP in the amount of $90 and is treated as holding US property in the amount of $90

UTP X (Non-

U.S.)

FS

FP

(For)

10%

$100 Loan

USP (U.S.)

Pledge Assets

as Security

for Loan

30% 70%

UTP Y (Non-

U.S.) 90%

UTP Z

DISPOSITION

51

Exit Strategies

Sale of partnership assets or interests source/character

Buy out other partner. Note Rev. Rul. 91-32 and the

Administration’s 2016 Budget proposal to codify the ruling

Partnership redeems out a partner – consider section 736,

source, and character

Liquidate partnership – sections 731, 704(c), 751(b), etc.

Incorporate partnership - Note section 367 issues

Partnership division

Section 1248 and Partnerships: Sale of Interest in

Partnership Holding CFC Stock Section 751(c) treats stock of a CFC held

through a partnership as a zero-basis unrealized

receivable in an amount equal to the potential

section 1248 dividend amount

CFC FMV 600

Partnership Basis in CFC 100

Gain on Sale 500

Potential Section 1248 Dividend Amt. 300

A domestic partner of the partnership recognizes

ordinary income to the extent of its share of any

gain that would have been treated as a dividend

under section 1248 had the partnership sold the

CFC stock directly

FMV Partnership Interest 360

Basis in Partnership Interest 60

Gain on Sale 300

Section 751(c) Ordinary Income

(Allocable Share of Potential Section

1248 Amount) 180

Section 741 Capital Gain 120

IRS position appears to be no FTCs and no QDI; see §1248(g)(2).

FMV: 600

Basis: 100

E&P: 300

FMV:

360

CFC

Sale of FJV

Partnership

Interest

40% 60%

FJV

(Foreign)

Foreign Co US Co

Section 1248: Sale of Partnership Interest and

Section 338 Election

Purchase of 100% of partnership interests is treated as a purchase of PS assets

under Rev. Rul. 99-6, enabling Buyer to make a §338 election for CFC, wiping

out E&P

If §751(c) and IRS view of §1248(g)(2) applies here, who takes E&P and

associated FTCs into account?

Buyer

“New”‏CFC

DE

deemed

asset sale

sell 100% of

partnership interests

CFC

40% 60%

E&P: 300

FJV

(Foreign)

Foreign Co US Co

Section 1248 and Partnerships: Sale of

Interest in Partnership Holding CFC Stock

Subpart F: Section 954(c)(4) treats as a

sale by CFC1 of its proportionate share of

assets of Foreign Partnership (i.e., CFC2

stock)

But:

Treated as a sale of CFC2 stock by

CFC1 for purposes of section 964(e)?

No;954‏(c)(4)‏says‏“only‏for‏purposes‏

of this section”

Deemed dividend to CFC1? No

Availability of FTCs? No

See section 1248(g)(2) CFC2

Disposition

40% 60%

FJV

(Foreign)

Foreign Co US Co

CFC1


CFC by Domestic Partnership

Disposition treated as a sale of CFC

stock by a U.S. person to which

section 1248 applies

Each partner allocated its

respective share of section 1248

dividend income and capital gain

Credits allowable to domestic

partners under Rev. Rul. 71-141

and section 902(c)(7)

QDI

CFC FMV 600

Partnership Basis in CFC 100

Gain on Sale 500

Section 1248: 300

Capital Gain: 200

CFC

Disposition

40% 60%

E&P: 300

JV

(U.S)

Foreign Co US Co


CFC by Foreign Partnership

Partners of Foreign Partnership

treated as selling or exchanging their

proportionate share of the stock of

CFC. Treas. Reg. §1.1248-1(a)(4)

CFC 600

Partnership Basis in CFC

100

Gain on Sale 500

Gain Allocable to

Domestic Partners (60% x 500) 300

E&P Allocable to

Domestic Partners (60% x 300) 180

Section 1248 180

Capital Gain 120

See Treas. Reg. § 1.1248-1(a)(5), Ex. 4.

Results are not different from

previous slide, but mechanics are

CFC

Disposition

40% 60%

E&P: 300

FJV

(Foreign)

Foreign Co US Co

PARTNERSHIPS AND SECTION

7874

Section 7874:

Acquisition of U.S. P/S by Foreign Corporation

.Section 7874 applies to a foreign corporation acquiring a trade or business of a U.S‏

partnership if:

• after the transaction partners in U.S. partnership own 60%

(or 80%) or more of a foreign corporation by reason of their ownership of interests in

the U.S. partnership,

• the foreign corporation directly or indirectly acquires substantially all the properties

constituting a trade or business of the U.S. partnership, and

• The foreign corporation and its subsidiaries do not have substantial business

activities in the country in which the foreign corporation is incorporated

o Temp Regulations (June 2012) adopt 3-part 25% test – assets, employees,

gross income

59

Anti-Inversion Legislation: Partnerships

Does section 7874 apply to wholly foreign operations of USP?

Dissolution of USP /conversion to FP subject to anti-avoidance rule?

EU-5

DE

EU-4

DE

EU-3

DE

EU-2

DE EU-1

DE

USP

US Non-Corporates

Anti-Inversion Acquisition o

Injected cash from IPO of Bermuda

Co disregarded in testing ownership

fraction received for U.S.

partnership under section

7874(c)(2)(B)

Treas. Reg. § 1.7874-4T (Jan. 2014)

expanded rule to certain private

transactions (see Notice 2009-78)

On April 4, 2016, Treas. Reg. §

1.7874-4T was amended to reflect

Notice 2014-52, Notice 2015-79 and

the new 2016 temporary regulations

Public

Shareholders

Foreign Parent

(Bermuda)

U.S.

Service

Partners/SHs

Limitations on Go-Private Transactions

As in the Notices, Treas. Reg. § 1.7874-4T excludes from the denominator of the

ownership fraction, stock issued by the foreign acquirer in exchange for

nonqualified property

The‏term‏“nonqualified‏property”‏is‏defined‏as

Cash and cash equivalents,

Marketable securities,

Disqualified obligations (not previously included in Notice 2009-78), or

Any other property acquired in a transaction with a principal purpose of avoiding the

purposes of section 7874, regardless of whether the transaction involves an indirect

transfer of nonqualified property

However, subject to an anti-abuse rule, a marketable interest in a corporation or

partnership‏that‏becomes‏a‏member‏of‏the‏foreign‏acquirer’s‏EAG‏will‏not‏be‏

treated as nonqualified property

This is the exception that allows stock issued by the foreign acquirer in exchange for the

publicly traded stock of a non-U.S. target to be counted in the denominator of the

ownership fraction

62

Disregard of Stock Transferred for Passive

Property

75%

(deemed

100%) FA

Pre-Transaction Structure Post-Transaction

Structure

USCo

Individual

A

25%

• Individual A transfers

USCo to FA in

exchange for 75 FA

shares.

• FJV transfers cash

(nonqualified

property) to FA in

exchange for 25 FA

shares.

• FA uses cash to

purchase foreign

assets

• The FJV transfer of

cash is disregarded;

Individual A deemed

to own 100% of FA.

Foreign

Assets

FJV

Partners

USCo

Individual

A Partners

PRS

Foreign

Assets

Third

Party

Cash

purchase

assets

cash

63

Disregard of Stock Transferred for Avoidance

Property

• Individual A transfers

USCo to FA in

exchange for 75 FA

shares.

• FJV buys foreign

assets that are not

nonqualified property,

transfers assets to FA

in exchange for 25

FA shares.

• Answer depends on

whether the FJV

transfer of assets has

as a principal

purpose the

avoidance of section

7874.

75% (?)

FA

USCo

Individual

A

25% (?)

Foreign

Assets

FJV

Partners

USCo

Individual

A Partners

FJV

Foreign

Assets

Third

Party

Pre-Transaction Structure Post-Transaction

Structure

cash

assets

assets

Treas. Reg. § 1.7874-4T contains a de minimis exception whereby the exclusion

rule for disqualified stock does not apply if:

The ownership continuity percentage is less than 5 percent (as measured by

vote and value and ignoring the diet dividend rule in Treas. Reg. § 1.7874-10T

and the cash box rule in Treas. Reg. § 1.7874-7T ), and

After the acquisition and all transactions related to the acquisition, the former

shareholders or partners of the acquired U.S. entity own less than 5 percent (as

measured by vote and value) of the foreign acquirer or any member of the EAG

Ownership is determined with attribution under section 318, as modified by

section 304(c)(3)(B)

The de minimis exception likely to apply when there is a cash purchase of a

domestic target with limited management rollover

Limitations on Go-Private Transactions

Anti-Inversion Legislation: Acquisition by Foreign Partnership

Regulations also apply to an acquisition of a U.S. corporation or‏

partnership by a publicly traded foreign partnership

• Section 7874(g) provided specific regulatory authority to prevent avoidance of

provision through, among other things, the use of pass-through entities

• Regulation can treat publicly traded foreign partnerships which are not treated

as corporations under section 7704(c) as foreign corporations to be tested under

section 7874

o If the other tests are satisfied, e.g.,‏the‏80%‏continuity‏test,‏then‏the‏“foreign‏

corporation”‏can‏be‏treated‏as‏a‏domestic‏corporation‏under‏section‏;7874‏if‏not,‏

remains a partnership

THE FOREIGN TAX CREDIT

67

Direct vs. Indirect Credit

Partnership: Direct

Credit

Corporation:

Indirect Credit

Partnership:

Indirect Credit

Foreign

Co US Co

FJV Co

Dividen

d

100

E&P

50 Tax

Foreign Co

FJV

US Co

100

Income

50 Tax

To avoid double taxation, a

foreign tax credit (FTC) is

provided under section 901,

which reduces the US tax liability

dollar-for-dollar (subject to the

FTC limitation)

Subject to the section 904

limitation, the 50 Tax is creditable

under section 901. Section

704(b) governs how the 50 of

creditable foreign tax expense

(CFTE) is allocated between the

partners

Section 902(c)(7) provides that for

purposes of claiming an indirect

credit, stock owned, directly or

indirectly, by a partnership is

treated as proportionately owned

by its partners

100

Income

50 Tax

Foreign Co

FJV

US Co

CFC

Dividen

d

Generally, when US Co includes FJV

Co’s‏earnings in US‏Co’s‏income, US Co

may claim FJV‏Co’s‏taxes as an FTC

under Section 902

When‏FJV‏Co’s‏earnings are distributed

(or treated as distributed) back to US

Co, then US Co may claim an FTC

Thus, a 100 distribution (dividend) from

FJV Co would entitle US Co to claim a

50 FTC (100% * 50)

68

Section 704(b) Regulations and FTCs

‏not‏do‏(”CFTEs“)‏Expenditures‏Tax‏Foreign‏Creditable‏of‏Allocations‏

have Substantial Economic Effect (“SEE”)‏and‏therefore,‏must‏be‏

allocated‏in‏accordance‏with‏the‏Partner’s‏Interest‏in‏the‏Partnership‏

(“PIP”)

Safe harbor – An allocation of CFTE is deemed to be in accordance‏

with PIP if:

• (1) the CFTE is allocated (whether or not pursuant to an express

provision in the partnership agreement) and reported on the

partnership return in proportion to the distributive shares of income to

which the CFTE relates, and

• (2) allocations of all other partnership items that materially affect the

CFTEs allocated to a partner are valid. (Treas. Reg. § 1.704-

1(b)(4)(viii)(a))

69

Section 704(b) Regulations and FTCs

Simple Case

Net Income

$500

$500

Tax Split

$100 75-25

$50 50-50

DRE1

DRE2

US Co:

DRE1: $375; $75 Tax

DRE2: $250; $25 Tax

Foreign Co:

DRE1: $125; $25 Tax

DRE2: $250; $25 Tax

DRE1: 500 Net Income; 100 Tax

DRE2: 500 Net Income; 50 Tax

FJV

Foreign Co U.S. Co

DRE1 DRE2

70

Inter-Branch Payments

FJV is engaged in Business A operations in

Country X and business B operations

Country Y that are conducted through

DRE1 and DRE2, respectively

The partnership agreement provides for

different allocations of the net income

attributable to business A and the B

business

DRE1 earns $100,000 and makes a

$75,000 payment to DRE2 that is

deductible in computing the Country X Tax

DRE2 earns $50,000 and also receives the

$75,000 payment from DRE1

DRE1 pays $10,000 of Country X Tax

DRE2 pays $25,000 of Country Y Tax US Income: $100,000

X Income: $25,000

Tax: $10,000

US Income: $50,000

Y Income: $125,000

Tax: $25,000

75% of income

DRE1

50% of

income from

DRE2

25% of income

from DRE1

50% of

income from

DRE2

$75,000

Interest

FJV

Foreign Co U.S. Co

50% 50%

DRE1 DRE2

71

Inter-Branch Payments (cont’d)

The‏$10,000‏of‏DRE1’s‏Country‏X‏taxes‏are‏

attributable to the Business A operations (net of

the interest payment) and the $10,000 of

Country Y taxes are attributable to the Business

B operations (without regard to the disregarded

interest payment)

The additional $15,000 of Country Y taxes are

imposed on the inter-branch interest payment

Provided the additional $15,000 of Country Y

taxes imposed on the inter-branch payment are

allocated to the same partner as the $75,000 of

income attributable to the disregarded payment,

the allocations will satisfy the section 704(b)

safe harbor

This can be accomplished by: (i) allocating the

Country Y taxes imposed on the inter-branch

payment in the same manner as the DRE1

income or (ii) allocating $75,000 of the DRE1

income in the same manner as the DRE2

income

US Income: $100,000

X Income: $25,000

Tax: $10,000

US Income: $50,000

Y Income: $125,000

Tax: $25,000

75% of income

DRE1

50% of

income from

DRE2

25% of income

from DRE1

50% of

income from

DRE2

$75,000

Interest

FJV

Foreign Co U.S. Co

50% 50%

DRE1 DRE2

72

Section 704(c) Example

US Co contributes property with a value of

15,000 and an adjusted basis of 0

Foreign Co a non-depreciable operating

business with contributes a value of 15,000

and a basis of 15,000

Revenues exceed expenses by 1,000 a year

In each year, the IP generates 1,000 of book

depreciation and 0 of tax depreciation

The parties anticipate the royalty income will

have substantially the same effect on their tax

liabilities‏as‏income‏from‏FJV’s‏contributed‏IP

The IP is sold at the end of year 15 for 15,000

At the end of year 15, the fair market values

of each of US. Co’s‏and‏Foreign‏Co’s‏

interests in FJV are 22,500

FJV

Foreign Co US Co

IP

FMV 15,000

AB 0

Non-Depreciable

Operating Business

FMV 15,000

AB 15,000

50% 50%

Business A: 500 Net Income; 100 Tax

Business B: 500 Net Income; 50 Tax

Bus A Bus B

73

Section 704(c) Effect on Allocations of CFTEs

A partner’s‏distributive‏share‏for‏purposes‏of‏the section 704(b) safe

harbor‏is‏the‏partner’s‏distributive‏share‏of‏taxable‏income‏(not‏section

704(b) book income), and is calculated by taking section 704(c) into

account

Items of built-in gain or loss must be allocated to the contributing

partner using one of three methods set out in the regulations

As a trap for the unwary, a foreign partner may be ignorant of section

704(c), and may negotiate its economic deal without taking section

704(c) into account

74

Gross Basis Withholding Taxes

FJV

Corp C Corp A

DREX DREZ DREY

Corp B

FJV is engaged in DREX operations in Country X,

DREY operations in Country Y and DREZ operations in

County Z, respectively.

The partnership agreement provides for different

allocations of the net income attributable to business A

and the B business

DREX earns $100,000 royalty income from unrelated

payors, on which no withholding tax is imposed.

Country X imposes a 30 percent net income tax on

DREX income.

DREX makes a royalty payment of $90,000 to DREY

that is deductible for Country X purposes and subject

to a 10 percent Country X withholding tax. DREY earns

no other income and Country Y does not tax any of the

DREY income.

DREY makes a royalty payment of $80,000 to DREZ.

DREZ earns no other income and Country Z does not

tax any of the DREZ income.

$100,000

<$90,000> $90,000

<$80,000>

$80,000

US:$100,000

X:$10,000

X Tax:$3,000

US: $0

Y:$10,000

X:$90,000

X Tax:$9,000

US: $0

X:$80,000

Tax:$0

75


FJV

Corp C Corp A

DREX DREZ DREY

Corp B

All partnership items from business X, excluding

CFTEs, are allocated 80 percent to Corp A and 10

percent to Corp B and Corp C.

All partnership items from business Y, excluding

CFTEs, are allocated 80 percent to Corp B and 10

percent to Corp A and Corp C.

All partnership items from business Z, excluding

CFTEs, are allocated 80% to Corp C and 10

percent to Corp A and Corp B.

$100,000

<$90,000> $90,000

<$80,000>

$80,000

US: $100,000

X: $10,000

X Tax:$3,000

US: $0

Y:$10,000

X:$90,000

X Tax:$9,000

US: $0

X:$80,000

Tax:$0

76


FJV

Corp C Corp A

DREX DREZ DREY

Corp B

$100,000

<$90,000> $90,000

<$80,000>

$80,000

US:

$100,000

X: $10,000

X

Tax:$3,000

US: $0

Y: $10,000

X: $90,000

X

Tax:$9,000

US: $0

X: $80,000

Tax:$0

Corp A:

DREX: $80,000; $9600 Tax

Corp B:

DREX: $10,000; $120 Tax

Corp C:

DREX: $10,000; $120 Tax

Net Income

$100,000

$0

$0

Tax Split

$12,000 80/10/10

$0 10/80/10

$0 10/10/80

DREX

DREY

DREZ

INBOUND INVESTMENT

78

Corporate USTOB vs. Partnership USTOB

US Co Foreign Co

FJV

USTOB

US Co Foreign Co

FJV Co

Foreign USTOB Partnership USTOB

Foreign Co will be deemed to engage in a business

conducted by a partnership of which it is a partner. See

section 875

If the partnership has a U.S. permanent establishment,

any partner will be deemed to have a PE

If‏the‏partnership‏engages‏in‏a‏“commercial‏activity”‏

within the meaning of section 892, any partner will be

treated as engaging in a commercial activity

Income effectively connected with the USTOB of FJV Co

will be taxable on a net basis to FJV Co at US statutory

rates

Foreign Co will not be deemed to be engaged in a US

trade or business or to have a US permanent

establishment

If FJV Co is a USRPHC, the sale of stock in FJV Co by

Foreign Co may result in gains being treated as U.S.

source ECI

USTOB

79

Revenue Ruling 91-32

Facts:

FP1, a nonresident alien individual,

owns an interest in PRS1, a

partnership

Some‏of‏PRS1’s‏assets‏are‏used‏or‏

held for use in a U.S. trade or

business

FP1 sells PRS1 and recognizes $100

of gain

Issue:

Whether the gain recognized by FP1

on its sale of PRS1 is subject to tax in

the U.S. as income effectively

connected with a U.S. trade or

business (ECI), and if so, how much

PRS1

FP1

Sale for $100

gain

Assets

Unrelated

Assets Value Basis

Cash 300,000 300,000

Non-U.S. Real Property 1,000,000 500,000

Non-U.S. Machinery 100,000 500,000

ECI Property 500,000 200,000

Total: 1,900,000 1,500,000

25% 75%

FMV = $475

Basis = $375

80

Revenue Ruling 91-32 Analysis:

Under section 875(1), FP1 is deemed to be

engaged in a U.S. trade or business by virtue of

PRS1 being engaged in a U.S. trade or business

Gain recognized by FP1 is capital gain pursuant to

section 741

Gain recognized on sale of PRS1 is attributable to

the U.S. office or fixed place of business of PRS1

and is thus both U.S. source and ECI, to the extent

attributable to ECI property

Unclear whether the amount of ECI recognized is

limited‏to‏“outside‏gain”‏in‏FP1’s‏partnership‏

interest (similar to FIRPTA look-through under

section 897(g)), or whether under a pure aggregate

approach ECI on the sale should be determined

solely‏by‏reference‏to‏PRSI’s‏ECI‏assets,‏where‏

ECI‏could‏potentially‏exceed‏gain‏inherent‏in‏FP1’s‏

partnership interest

Due to uncertainty and questionable statutory and

regulatory authority, the 2016 Obama Budget

Proposal seeks to codify Rev. Rul. 91-32 and

impose withholding

PRS1

FP1

Sale for $100

gain

Assets

Unrelated

25% 75%

FMV = $475

Basis = $375

Assets Value Basis

Cash 300,000 300,000

Non-U.S. Real Property 1,000,000 500,000

Non-U.S. Machinery 100,000 500,000

ECI Property 500,000 200,000

Total: 1,900,000 1,500,000

81

FIRPTA: Section 897(g)

Where a foreign partner disposes of its

interest in a partnership, section 897(g)

requires‏gain‏to‏be‏recognized‏as‏ECI‏“to‏the‏

extent‏attributable‏to”‏a‏USRPI

Subject to 10 percent withholding under

section 1445 if 1) 50 percent or more of the

gross assets of FJV constitute USRPIs and

2) 90 percent or more of the value of the

gross assets consist of USRPIs and cash or

cash equivalents. See Treas. Reg. § 1.897-

7T

Query whether there is a relationship to any

new withholding tax under the 2016 Budget

Proposal’s‏proposed‏codification‏of‏Rev.‏Rul.‏

91-32

US Co

FJV

Foreign Co

USRPI

Sale of

Partnership

Interest

82

Types of Partnership Debt

• Partnership Owns USRPIs

• A‏“straight‏loan”‏to‏the‏partnership‏is‏not‏a‏USRPI,‏because‏it‏qualifies‏

as‏an‏“interest‏solely‏as‏a‏creditor.”‏‏Treas.‏Reg.1.897-1 §‏(d)(1)

• A‏“participating‏loan”‏to‏the‏partnership‏is‏a‏USRPI.‏Treas.‏Reg.‏§

1.897-1(d)(2); -1(d)(3)(i)(B)

• Presumably, a convertible loan to the partnership is also a USRPI

OTHER RECENT GUIDANCE

84

Proposed Section 385 Regulations

On April 4, 2016, the United States Treasury and the IRS published broadly applicable

proposed regulations under Code section 385 that would:

• Authorize the IRS to treat certain related-party interests as part stock and part debt for

federal tax purposes;

• Establish contemporaneous documentation requirements that must be satisfied for

certain related-party debt to be respected for federal tax purposes; and

• Treat certain related-party debt as stock for all purposes of the Code when issued in

connection with certain distributions and acquisitions.

The Proposed Regulations have complex effective date provisions for the foregoing, but

generally do not have substantive effect until the Proposed Regulations are finalized.

Treasury‏has‏stated,‏however,‏that‏it‏intends‏to‏“move‏swiftly”‏to‏finalize‏the‏Proposed‏

Regulations.

85

Overview – Summary of Provisions

• Bifurcation of Debt Instruments (Prop. Reg. § 1.385-1)

• The Proposed Regulations grant the Commissioner the ability to treat certain related

party debt instruments as part stock and part indebtedness.

• This‏would‏allow‏the‏Service‏to‏challenge‏taxpayer’s‏treatment‏of‏related‏party‏debt‏

without‏an‏“all‏or‏nothing”‏result.‏‏

• Documentation Requirements (Prop. Reg. § 1.385-2)

• The Proposed Regulations would require documentation and information

requirements for certain related party debt to be treated as debt for U.S. federal

income tax purposes.

• These documentation and information requirements are significant in scope,

applying to contemporaneous documentation and information, as well as ongoing

requirements,‏and‏may‏require‏a‏substantial‏change‏in‏a‏taxpayer’s‏substantiation‏

of intragroup cash funding.

86


• Prohibited Transactions Involving Related Party Debt (Prop. Reg. § 1.385-3)

• The Proposed Regulations treat certain related party debt issued in specified

prohibited transactions as equity – generally, (i) distributions of a note; (ii)

acquisitions of related party stock, and (iii) asset reorganizations.

• The‏Proposed‏Regulations‏extend‏this‏treatment‏to‏“funding”‏of‏similar‏transactions,‏

with funding presumptive if it occurs within a 72-month period within which the

prohibited transaction occurs.

• The‏“funding”‏rule‏does‏not‏turn‏on‏a‏“tracing”‏concept‏and‏applies‏whenever‏

the issuer of the debt instrument transfers property in one of the prohibited

transactions.

• The‏“funding”‏rule‏has‏broad‏application‏and‏will‏require‏the‏monitoring‏of‏

internal cash flows before and after any potential prohibited transaction and

ensuring that any potential prohibited transaction does not involve a potential

issuer of related party debt before it occurs. This, too, may require a

substantial change in the processes by which related parties account for

intragroup cash flows.

• There is an anti-abuse rule that prohibits taxpayers from affirmatively relying on the

Proposed Regulations in order to secure U.S. federal income tax benefits.

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• Related Party Debt Between Consolidated Group Members (Prop. Reg. § 1.385-4)

• In general, the Proposed Regulations treat all members of a consolidated group as a

single entity for purposes of applying the Proposed Regulations.

• Accordingly, intragroup debt is not subject to recharacterization under the Proposed

Regulations, although transfers of such debt outside of the group may cause the

Proposed Regulations to apply.

88

• Prop. Reg. §§ 1.385-1 and 1.385-2: these sections apply to any instruments issued or

deemed issued on or after the date these regulations are published as final regulations

in the Federal Register.

• Prop. Reg. §§ 1.385-3 and 1.385-4: These sections generally apply to debt instruments

issued after April 4, 2016. Where these regulations otherwise would treat a debt

instrument as stock prior to the date of publication of the final regulations in the Federal

Register, the debt instrument is treated as indebtedness until 90 days after the date of

publication of these regulations as final. After such time, to the extent the debt

instrument‏is‏held‏by‏a‏member‏of‏the‏issuer’s‏expanded‏group,‏the‏debt‏instrument‏is‏

deemed to be exchanged for stock on the date 90 days after publication.

• For Prop. Reg. § 1.385-3‏and‏the‏“funding”‏rule,‏a‏prohibited‏transaction‏that‏generally‏

occurs before April 4, 2016 will not be taken into account (even though the debt

instrument may have been issued after April 4, 2016).

• Note‏that‏the‏effective‏date‏provisions‏refer‏to‏“deemed‏issuances”‏that‏may‏cover‏a‏

deemed issuance as a result of a significant modification under Treas. Reg. § 1.1001-3.

Effective Dates

International Joint Venture Issues - Practising Law Institute

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