International Tax Alert - February 2017

Transfers of Certain Property by U.S. Persons to Partnerships with Related Foreign Partners

Summary

Recently, the Department of the Treasury and the Internal Revenue Service (hereinafter, collectively “Treasury”) issued temporary (T.D. 9811) and proposed (REG-127203-15) regulations that address transfers of appreciated property by U.S. persons to partnerships with foreign partners related to the transferor.  The regulations override the rules under Section 721(a) providing for non-recognition of gain on a contribution of property to a partnership in exchange for an interest in the partnership, unless the partnership adopts the remedial method and certain other requirements are satisfied.  The regulations affect U.S. partners in domestic or foreign partnerships.
 
The regulations largely adopt the rules provided in Notice 2015-54 with certain modifications. Some of the key modifications, as further discussed below, include:

1. Modifying the requirement for the U.S. transferor and related foreign partners to have 80 percent or more of the interests in partnership capital, profits, deductions or losses, instead of 50 percent for “Section 721(c) Partnerships.”  See Overview Sections 1 and 2 below;
2. Modifying the “gain deferral method” such that property that gives rise to income effectively connected with a U.S. trade or business is generally not subject to the remedial allocation method or the consistent allocation method.  See Overview Section 3 below;
3. Modifying the remedial allocation method as to anti-churning property.  See Overview Section 3 below; and
4. Exempting contributions of property by “unrelated” U.S. transferors (i.e., a U.S. transferor that does not, together with related persons with respect to it, satisfy the ownership requirement).  See Overview Section 2 below.

 

Background

The Taxpayer Relief Act of 1997 (the “1997 Act”), P.L. 105-34, granted the Secretary regulatory authority in Section 721(c) to override the application of the non-recognition provision of Section 721(a) to gain realized on the transfer of property to a partnership (domestic or foreign) if the gain, when recognized, would be includible in the gross income of a person other than a U.S. person. In the 1997 Act, Congress also enacted Section 367(d)(3), which provides the Secretary regulatory authority to apply the rules of Section 367(d)(2) to transfers of intangible property to partnerships in circumstances consistent with the purposes of Section 367(d).  Congress enacted Section 367 (and its predecessor) in order to prevent U.S. persons from avoiding U.S. tax by transferring appreciated property to foreign corporations using non-recognition transactions.
 
Section 721(a) provides a general rule that no gain or loss is recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.  Because Section 367 applies only to the transfer of property to a foreign corporation, absent regulations under Section 721(c) or Section 367(d)(3), a U.S. person generally does not recognize gain on the contribution of appreciated property to a partnership with foreign partners.
 
On August 6, 2015, Treasury issued Notice 2015-54 (the “notice”), which describes regulations to be issued under Section 721(c).  The notice states that future regulations generally will override the application of the non-recognition rule in Section 721(a) to gain realized on the transfer of property to a partnership (domestic or foreign) in certain circumstances in which the gain, when recognized, ultimately would be includable in the gross income of a related foreign person.  The notice further states that future regulations will allow for the continued application of Section 721(a) to transfers to partnerships with related foreign partners when certain requirements intended to protect the U.S. tax base are satisfied.  The notice described these requirements, in addition to others, as the “gain deferral method.”  For a discussion of the notice, see our Tax Alert, “New Notice 2015-54 Addresses Certain Contributions Made to Partnerships,” dated August 2015.

 

Overview of the Temporary Regulations

The temporary regulations adopt the rules that were described in the notice, with certain modifications.  Some of the key items to the temporary regulations are summarized below.

 

1. Definitions

The notice states that future regulations would provide that a partnership is a Section 721(c) partnership if a U.S. transferor contributes Section 721(c) property (as defined in the notice) to the partnership, and, after the contribution and any transactions related to the contribution, (i) a related foreign person is a direct or indirect partner, and (ii) the U.S. transferor and related persons own (directly or indirectly) more than 50 percent of the interests in partnership capital, profits, deductions, or losses.  The temporary regulations, however, increase the threshold from a “more than 50 percent” test to an “80 percent or more” test (ownership requirement).
 
Section 721(c) Partnership:  A partnership (domestic or foreign) is a Section 721(c) partnership if there is a contribution of Section 721(c) property to the partnership and, after the contribution and all transactions related to the contribution: (i) a related foreign person with respect to the U.S. transferor is a direct or indirect partner in the partnership; and (ii) the U.S. transferor and related persons own 80 percent or more of the interests in partnership capital, profits, deductions, or losses.^[1]

Section 721(c) Property: The temporary regulations define Section 721(c) property as property, other than excluded property, with built-in gain that is contributed to a partnership by a U.S. transferor.^[2]  In addition, the temporary regulations provide rules that deem certain property of a tiered partnership to be Section 721(c) property.^[3]  When an interest in a partnership is contributed, the partnership interest, if it is not excluded property, is the Section 721(c) property.
 
Excluded Property: The temporary regulations define excluded property as (i) a cash equivalent; (ii) a security within the meaning of Section 475(c)(2), without regard to Section 475(c)(4); (iii) an item of tangible property with built-in gain that does not exceed $20,000 or with an adjusted tax basis in excess of book value (built-in loss); and (iv) an interest in a partnership that holds (directly, or indirectly, through interests in one or more partnerships that are not excluded property under this clause (iv)) property of which 90 percent or more of the value consists of property described in clauses (i) through (iii) (partnership interest exclusion).^[4]
 
Remaining Built-in Gain: The temporary regulations include a new term, “remaining built-in gain.”  Section 1.721(c)-1T(b)(13)(i) generally defines remaining built-in gain, with respect to an item of Section 721(c) property that is subject to the gain deferral method, as the built-in gain, reduced by decreases in the difference between the property's book value and adjusted tax basis. However, subsequent increases or decreases to the property's book value due to a revaluation other than a revaluation required under these temporary regulations for tiered partnerships are not taken into account in determining remaining built-in gain. The temporary regulations also provide rules for determining remaining built-in gain in the case of tiered partnerships.^[5]

 

2. General Rule of Gain Recognition

Section 1.721(c)-2T(b) provides the general rule that non-recognition under Section 721(a) will not apply to gain realized upon a contribution of Section 721(c) property to a Section 721(c) partnership.  However, this general rule does not apply to a direct contribution by a U.S. transferor if the U.S. transferor and related persons with respect to the U.S. transferor do not own 80 percent or more of the interests in partnership capital, profits, deductions, or losses.  This 80 percent related ownership threshold is a significant departure from the notice that required only 50 percent related ownership.
 
Section 1.721(c)-2T(c) provides a de minimis exception to the general rule. Under the de minimis exception in the temporary regulations, contributions of Section 721(c) property will not be subject to immediate gain recognition if the sum of all built-in gain for all Section 721(c) property contributed to a Section 721(c) partnership during the partnership's taxable year does not exceed $1 million.
 
Section 1.721(c)-2T(d)(1) provides a look-through rule for identifying a Section 721(c) partnership in certain tiered-partnership structures.  Specifically, subject to an exception for a technical termination of a partnership, if a U.S. transferor is a direct or indirect partner in a partnership (upper-tier partnership) and the upper-tier partnership contributes all or a portion of its property to another partnership (lower-tier partnership), then, for purposes of determining if the lower-tier partnership is a Section 721(c) partnership, the U.S. transferor is treated as contributing to the lower-tier partnership its share of the property actually contributed by the upper-tier partnership to the lower-tier partnership.

3. Gain Deferral Method

Section 1.721(c)-3T describes the gain deferral method, which generally must be applied in order to avoid the immediate recognition of gain upon a contribution of Section 721(c) property to a Section 721(c) partnership.  Section 1.721(c)-3T(b) provides the five general requirements for applying the gain deferral method to an item of Section 721(c) property:

1. The Section 721(c) partnership adopts the remedial allocation method and allocates Section 704(b) items of income, gain, loss, and deduction with respect to the Section 721(c) property in a manner that satisfies the consistent allocation method (as described below);

2. The U.S. transferor recognizes gain equal to the remaining built-in gain with respect to the Section 721(c) property upon an acceleration event, or an amount of gain equal to a portion of the remaining built-in gain upon a partial acceleration event or certain transfers to foreign corporations described in Section 367;

3. Certain procedural and reporting requirements are satisfied;

4. The U.S. transferor extends the period of limitations on assessment of tax; and

5. The rules for tiered partnerships are satisfied if either the Section 721(c) property is an interest in a partnership or the Section 721(c) property is described in the partnership look-through rule in Section 1.721(c)-2T(d)(1).

The temporary regulations employ two general principles in applying the gain deferral method to tiered partnerships.  First, if the Section 721(c) property is an interest in a partnership, the contribution of that partnership interest, and not the indirect contribution of the underlying property of the lower-tier partnership, to a Section 721(c) partnership is subject to Section 721(c), and the gain deferral method applies to the contribution of the interest.  Second, the gain deferral method must also be adopted at all levels in the ownership chain.
 
The temporary regulations provide that a contribution of Section 721(c) property that gives rise to income effectively connected with a U.S. trade or business (“ECI property”) is subject to immediate gain recognition if the gain deferral method is not applied. However, the temporary regulations modify the gain deferral method such that ECI property is not subject to the remedial allocation method or the consistent allocation method provided certain conditions are satisfied.^[6] All the other requirements of the gain deferral method apply with respect to ECI property. Thus, a U.S. transferor must recognize gain upon an acceleration event with respect to ECI property, including when property ceases to be ECI property, and satisfy the procedural and reporting requirements with respect to ECI property.^[7]
 
The temporary regulations revise the remedial allocation method in Section 1.704-3(d) as to related partners when a Section 721(c) partnership is applying the gain deferral method with respect to Section 197(f)(9) intangible property (e.g., goodwill and going concern value that was non-amortizable before the enactment of Section 197).  The revised rule requires the partnership to amortize the portion of the partnership's book value in the Section 197(f)(9) intangible property that exceeds its adjusted tax basis in the property.  Accordingly, the allocation of book amortization to a noncontributing partner will result in a ceiling rule limitation to the extent of this allocation of book amortization.  If a noncontributing partner is a related person with respect to the U.S. transferor, the temporary regulations provide that, solely with respect to the related noncontributing partner, the partnership must increase the adjusted tax basis of the property by the amount of the difference between the book allocation of the item to the related person and the tax allocation of the same item to the related person and allocate remedial income in the same amount to the U.S. transferor.^[8]
 
As noted above, in order to avoid immediate gain recognition, taxpayers are required to apply the remedial allocation method in a manner that satisfies the consistent allocation method.  The consistent allocation method, which is applied on a property by property basis, requires a Section 721(c) partnership to allocate the same percentage of each book item of income, gain, deduction, and loss “with respect to the Section 721(c) property” to the U.S. transferor.  A regulatory allocation of book income, gain, deduction, or loss with respect to Section 721(c) property will be deemed to satisfy the consistent allocation method if the allocation is (i) an allocation of income or gain to the U.S. transferor; (ii) an allocation of deduction or loss to partner other than a U.S. transferor; or (iii) treated as a partial acceleration event (as described below).  It should be noted that an allocation of a creditable foreign tax expenditure as defined in Section 1.704-1(b)(4)(viii)(b), is not subject to the consistent allocation method.
 
The consistent allocation method is intended to prevent a U.S. transferor from rendering the remedial allocation method ineffective by, for example, having the partnership allocate a higher percentage share of book depreciation to the U.S. transferor (which would reduce the U.S. transferor's remedial income inclusion) than the U.S. transferor's percentage share of income or gain with respect to the property, which would result in shifting the gain (and taxable income) to related foreign persons that are direct or indirect partners in the partnership.

4. Acceleration Events

Section 1.721(c)-4T provides rules regarding acceleration events which apply on a property-by-property basis.  When an acceleration event occurs with respect to Section 721(c) property, remaining built-in gain in the property must be recognized and the gain deferral method no longer applies, subject to certain exceptions.
 
Subject to certain exceptions detailed below, an acceleration event with respect to Section 721(c) property is any event that either would reduce the amount of remaining built-in gain that a U.S. transferor would recognize under the gain deferral method if the event had not occurred or could defer the recognition of the remaining built-in gain.  An acceleration event includes a contribution of Section 721(c) property to another partnership by a Section 721(c) partnership and a contribution of an interest in a Section 721(c) partnership to another partnership.  The temporary regulations provide that an acceleration event will not occur because of a reduction in remaining built-in gain in an interest in a partnership that is a Section 721(c) property that occurs as a result of allocations of book items of deductions and loss, or tax items of income and gain.^[9]
 
Under the temporary regulations, an acceleration event with respect to Section 721(c) property occurs when any party fails to comply with a requirement of the gain deferral method with respect to that property.^[10]  An acceleration event will not occur solely as a result of a failure to comply with a procedural or reporting requirement of the gain deferral method if that failure is not willful and relief is sought under the prescribed procedures.^[11]
 
Under the temporary regulations, a U.S. transferor may affirmatively treat an acceleration event as having occurred with respect to Section 721(c) property by recognizing the remaining built-in gain with respect to that property and satisfying the reporting required by Section 1.721(c)-6T(b)(3)(iv).^[12]  In addition, certain basis adjustments generally must be made.^[13]

5. Acceleration Event Exceptions

Section 1.721(c)-5T identifies the following categories of exceptions to acceleration events, which, like acceleration events, apply on a property-by-property basis:

1. Termination events,^[14] in which case, the gain deferral method ceases to apply to the Section 721(c) property;

2. Successor events,^[15] in which case, the gain deferral method continues to apply to the Section 721(c) property but with respect to a successor U.S. transferor or a successor Section 721(c) partnership, as applicable;

3. Partial acceleration events,^[16] in which case, a U.S. transferor recognizes an amount of gain that is less than the full amount of remaining built-in gain in the Section 721(c) property and the gain deferral method continues to apply;

4. Transfers described in Section 367 of Section 721(c) property to a foreign corporation, in which case, the gain deferral method ceases to apply and a U.S. transferor recognizes an amount of gain equal to the remaining built-in gain attributable to the portion of the Section 721(c) property that is not subject to tax under Section 367;^[17] and

5. Fully taxable dispositions of a portion of an interest in a Section 721(c) partnership, in which case, the gain deferral method continues to apply for the retained portion of the interest.^[18]

 

6. Procedural and Reporting Requirements

To comply with the gain deferral method, the notice described regulations that would be issued requiring reporting of a gain deferral contribution and annual reporting with respect to the Section 721(c) property to which the gain deferral method applies.  The temporary regulations implement the rules described in the notice and Section 1.721(c)-6T provides the procedural and reporting requirements.

7. Effective/Applicability Dates

The applicability dates of the temporary regulations generally relate back to the issuance of the notice.
 
Accordingly, in general, the temporary regulations apply to contributions occurring on or after August 6, 2015, and to contributions occurring before August 6, 2015, resulting from an entity classification election made under Section 301.7701-3 that is filed on or after August 6, 2015 (the “general applicability date”).  However, new rules, including any substantive changes to the rules described in the notice, apply to contributions occurring on or after January 18, 2017, or to contributions occurring before January 18, 2017, resulting from an entity classification election made under Section 301.7701-3 that is filed on or after January 18, 2017. Taxpayers may, however, elect to apply those new rules and substantive changes to the rules described in the notice to a contribution occurring on or after the general applicability date.  The election is made by reflecting the application of the relevant rule on a timely filed or amended return.
 
The Temporary Regulations are scheduled to expire on January 17, 2020.
 
For dates of applicability, see Sections 1.197-2T(l)(5)(i), 1.704-1T(f), 1.704-3T(g)(1), 1.721(c)-1T(e), 1.721(c)-2T(e), 1.721(c)-3T(e), 1.721(c)-4T(d), 1.721(c)-5T(g), 1.721(c)-6T(g), and 1.6038B-2T(j)(4)(i).

 

BDO Insights

BDO can assist taxpayers with understanding the complexities of these rules. While the temporary regulations scale back the application of these rules as compared to the notice, taxpayers should continue to consider the application of these rules when transferring appreciated property to a partnership with a related foreign partner. 

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