International Tax Alert - November 2016

November 2016

The Service and Treasury Finalize Regulations under Section 956 Involving Partnerships 

Summary

On November 3, 2016, the Department of the Treasury (“Treasury”) and the Internal Revenue Service (“Service”) published final regulations (TD 9792) that provide rules regarding the treatment as U.S. property of property held by a controlled foreign corporation (“CFC”) in connection with certain transactions involving partnerships. In addition, the final regulations provide rules for determining whether a CFC is considered to derive rents and royalties in the active conduct of a trade or business for purposes of determining Subpart F income, as well as rules for determining whether a CFC holds U.S. property as a result of certain related party factoring transactions.


Details

Certain key items detailed in the preamble to the final regulations (the “preamble”) and certain changes made by the final regulations to the Section 956 proposed regulations published in 2015 and in 1988 are discussed below.
 
  1. Partnership Property Indirectly Held by a CFC Partner
Proposed §1.956-4(b)(1) provided that a CFC partner in a partnership is treated as holding its attributable share of property held by the partnership and for purposes of Section 956, a partner’s adjusted basis in the property of the partnership equals the partner’s attributable share of the partnership’s adjusted basis in the property.
 
  1. Revenue Ruling 90-112’s Outside Basis Limitation
Treasury and the Service published Revenue Ruling 90-112 on December 31, 1990, that held that a CFC that is a partner in a partnership is treated as indirectly holding property held by the partnership when the property would be U.S. property if the CFC held it directly. However, the revenue ruling included a limitation providing that the amount of U.S. property taken into account for purposes of Section 956 when a CFC partner indirectly owns property through a partnership is limited by the CFC’s adjusted basis in the partnership.
 
The preamble notes that Treasury and the Service have determined that an outside basis limitation should not be incorporated into the rule in proposed §1.956-4(b)(1). Revenue Ruling 90-112 is obsoleted.
 
  1. Consistent Use of Liquidation Value Percentage Method
In contrast to the rule provided in proposed §1.956-4(b) providing that a CFC partner’s attributable share of partnership property is determined in accordance with the CFC partner’s liquidation value percentage, proposed §1.956-4(c) provided that a partner’s share of a partnership obligation is determined in accordance with the partner’s interest in partnership profits. The final regulations retain the liquidation value percentage method set forth in proposed §1.956-4(b), and revise the general rule in proposed §1.956-4(c) to implement the liquidation value percentage method.
 
  1. Time for Determining the Liquidation Value Percentage
Proposed §1.956-4(b)(2)(i) provided that the liquidation value percentage of partners in a partnership should be determined upon the occurrence of events described in §1.704-1(b)(2)(iv)(f)(5) or §1.704-1(b)(2)(iv)(s)(1) (“revaluation events”). In light that partners’ relative economic interests in the partnership may change significantly as a result of allocations of income or other items under the partnership agreement even in the absence of a revaluation event, §1.956-4(b)(2)(i) of the final regulations provides that a partner’s liquidation value percentage must be re-determined in certain additional circumstances. Specifically, if the liquidation value percentage determined for any partner on the first day of the partnership’s taxable year would differ from the most recently determined liquidation value percentage of that partner by more than 10 percentage points, then the liquidation value percentage must be re-determined on that day even in the absence of a revaluation event.
 
  1. Obligations of Foreign Partnerships
The final regulations adopt the general aggregate approach that was contained in proposed §1.956-4(c)(1) (with certain modifications) as it relates to obligations of foreign partnerships.  More specifically, final §1.956-4(c)(1) generally provides that an obligation of a foreign partnership is treated as a separate obligation of each of the partners in the partnership to the extent of each partner’s share of the obligation. The final regulations provide that a partner’s share of the partnership’s obligation is determined in accordance with the partner’s liquidation value percentage as provided in §1.956-4(b)(2)(i) (without regard to the rules in §1.956-4(b)(2)(ii) relating to special allocations). The final regulations also include an exception for obligations of partnerships in which neither the lending CFC nor any person related to the lending CFC is a partner as well as a special obligor rule in the case of certain partnership distributions. See below for applicability dates.
 
  1. Exceptions from General Rule of Aggregate Treatment
Proposed §1.956-4(c)(2) provides an exception from the aggregate treatment of proposed §1.956-4(c)(1) that applies if neither the CFC that holds the obligation (or is treated as holding the obligation) nor any person related to the CFC (within the meaning of §954(d)(3)) is a partner in the partnership on the CFC’s quarterly measuring date on which the treatment of the obligation as U.S. property is being determined. Certain comments recommended adding additional exceptions to the general rule of aggregate treatment.
 
The preamble notes that Treasury and the Service have concluded that there is no reason to provide a more expansive exception from U.S. property treatment for obligations of a foreign partnership with certain U.S. persons as partners than would apply with respect to obligations incurred directly by those same U.S. persons. In addition, the Treasury and the Service have determined that the additional exceptions to aggregate treatment suggested in the comments are not warranted.
 
  1. Special Obligor Rule in the Case of Certain Distributions
The 2015 proposed regulations included a special funded distribution rule that increases the amount of a foreign partnership obligation that is treated as U.S. property when the following requirements are satisfied: (i) a CFC lends funds (or is a pledgor or guarantor with respect to a loan) to a foreign partnership whose obligation is, in whole or in part, U.S. property with respect to the CFC pursuant to proposed §1.956-4(c)(1) and existing §1.956-2(a); (ii) the partnership distributes an amount of money or property to a partner that is related to the CFC (within the meaning of §954(d)(3)) and whose obligation would be U.S. property if held (or treated as held) by the CFC; (iii) the foreign partnership would not have made the distribution but for a funding of the partnership through an obligation held (or treated as held) by the CFC; and (iv) the distribution exceeds the partner’s share of the partnership obligation as determined in accordance with the partner’s interest in partnership profits. When these requirements are satisfied, proposed §1.956-4(c)(3) provided that the amount of the partnership obligation that is treated as an obligation of the distributee partner (and thus as U.S. property held by the CFC) is the lesser of the amount of the distribution that would not have been made but for the funding of the partnership and the amount of the partnership obligation.
 
The final regulations clarify the funded distribution rule by providing with respect to the “but for” requirement in proposed §1.956-4(c)(3) that a foreign partnership will be treated as if it would not have made a distribution of liquid assets but for a funding of the partnership through obligations held (or treated as held) by a CFC to the extent the foreign partnership did not have sufficient liquid assets to make the distribution immediately prior to the distribution, without taking into account the obligations.
 
  1. Other Key Items
Besides the items detailed above, the final regulations also include comments and details on the following items:
 
  1. Finalization of the “active rents and royalties” exception to Subpart F income.
  2. Changes to §1.956-1, reflecting statutory changes enacted in 1993, regarding the methodology for calculating the amount determined under Section 956.
  3. New examples that illustrate the distinction between funding transactions that are subject to the anti-avoidance rule in §1.956-1(b) and common business transactions to which the anti-avoidance rule does not apply.
  4. Finalization of rules related to property acquired by a CFC in certain related party factoring transactions.
  5. Revisions and clarifications to the definition of special allocation for purposes of determining a partner’s attributable share of partnership property.
  6. Introduction of a new proposed rule which provides that a partner’s attributable share of property of a controlled partnership is determined solely in accordance with the partner’s liquidation value percentage, without regard to any special allocations.
 

Effective/Applicability Dates

The rules in §1.954-2(c)(1)(i) and (d)(1)(i) (regarding the active development test) apply to rents or royalties, as applicable, received or accrued during taxable years of CFCs ending on or after September 1, 2015, and to taxable years of U.S. shareholders in which or with which such taxable years end, by only with respect to property manufactured, produced, developed or created, or, in the case of acquired property, property to which substantial value has been added, on or after September 1, 2015.
The rules in §1.954-2(c)(1)(iv), (c)(2)(ii), (d)(1)(ii) and (d)(2)(ii) (regarding the active marketing test), as well as the rules in §1.954-2(c)(2)(iii)(E), (c)(2)(viii), (d)(2)(iii)(E), and (d)(2)(v) (regarding cost-sharing arrangements), apply to rents or royalties, as applicable, received or accrued during taxable years of CFCs ending on or after September 1, 2015, and to taxable years of U.S. shareholders in which or with which such taxable years end, to the extent that such rents or royalties are received or accrued on or after September 1, 2015.
 
The Section 956 anti-avoidance rules in §1.956-1(b) apply to taxable years of CFCs ending on or after September 1, 2015, and to taxable years of U.S. shareholders in which or with which such taxable years end, with respect to property acquired, including property treated as acquired as the result of a deemed exchange of property pursuant to Section 1001, on or after September 1, 2015.
 
The rules regarding factoring transactions in §1.956-3 (other than §1.956-3(b)(2)(ii)) apply to trade or service receivables acquired (directly or indirectly) after March 1, 1984.
 
The remaining rules in the final regulations apply to taxable years of CFCs ending on or after November 3, 2016 (the date the final regulations were published in the Federal Register), and taxable years of U.S. shareholders in which or with which such taxable years end. In general, these remaining rules apply to property acquired, or pledges or guarantees entered into, on or after September 1, 2015, including property considered acquired, and pledges and guarantees considered entered into, on or after September 1, 2015, as a result of a deemed exchange pursuant to Section 1001. See §1.956-4(c) (dealing with obligations of foreign partnerships); §§ 1 1.956-2(c), 1.956-4(d), and 1.956-1(e)(2) (dealing with pledges and guarantees, including pledges and guarantees by a partnership and with respect to obligations of a foreign partnership); and §1.956-3(b)(2)(ii) (dealing with trade and service receivables acquired from related U.S. persons indirectly through nominees, pass-through entities, or related foreign corporations). Two rules, however, apply to all obligations held on or after November 3, 2016. See §§1.956-2(a)(3) and 1.956-4(e) (dealing with obligations of disregarded entities and domestic partnerships, respectively). Finally, §1.956-4(b) (dealing with partnership property indirectly held by a CFC) applies to property acquired on or after November 3, 2016.
 
Revenue Ruling 90-112 is obsolete as of November 3, 2016.

For additional details see §§1.956-1 through 1.956-4 and 1.954-2, TD 9792, REG-122387-16 and REG-114734-16.
 

BDO Insights

Taxpayers who are partners in foreign partnerships should consider the implications of the rules discussed above. BDO can help our clients understand the application and implication of these new final regulations.   
 

For more information, please contact one of the following practice leaders:
 
Robert Pedersen
Partner and International Tax Practice Leader
 
         Chip Morgan          Partner 
 

 
Joe Calianno
Partner and International Tax Technical Practice Leader 
  Brad Rode
Partner 
 

 
William F. Roth III
Partner, National Tax Office
  Jerry Seade
Principal 

 
Scott Hendon
Partner 
  Monika Loving
Partner 

 
Annie Lee
Partner
  Sean Dokko
Senior Manager