The IRS concluded in a Field Attorney Advice (FAA 20204201F) that the Section 704(c) allocation method use by a partnership between a U.S. corporation and its domestic and foreign affiliates was unreasonable under the anti-abuse rule in the Section 704(c) regulations.
The FAA’s facts predate the application of regulations under Section 721(c). As such, similar situations similar are likely now addressed by the Section 721(c) regulations. Nonetheless, the FAA sheds light on the potential application of the Section 704(c) anti-abuse rule generally, suggesting that the IRS has a relatively low threshold in applying it.
In the FAA, a U.S. corporation and its wholly owned domestic subsidiary contributed intangibles to a foreign entity, causing that entity to convert from a disregarded entity to a partnership for U.S. federal income tax purposes. The contributed intangibles had significant built-in gain (i.e., high fair-market value and an adjusted basis of $0), and thus constituted “Section 704(c) property” to the domestic contributors. The contributed intangibles were amortizable for Section 704(b) book purposes, but because they had zero tax basis, they would not generate amortization deductions for tax purposes, causing the ceiling rule limitation in the Section 704(c) regulations to apply. The value of the contributed intangibles was expected to decline significantly once their corresponding patent period expired.
The partnership selected the traditional method with a limited back-end curative gain-on-sale allocation in applying Section 704(c). That is, upon a taxable disposition of one of the contributed intangibles, the partnership would make a curative allocation of tax gain to the domestic partners to cure any prior ceiling rule limitations. As long as the partnership continued to own the contributed intangibles, the shift of Section 704(c) built-in gain to the foreign partner would continue. A sale of the contributed intangible would end this shifting of taxable income to the foreign partner. However, the taxpayer had indicated at the outset that there was no intention of selling any of the contributed intangibles.
The FAA considers whether the partnership’s selected Section 704(c) method falls within the Section 704(c) anti-abuse rule (Treas. Reg. Sec. 1.704-3(a)(10)), which states that a Section 704(c) allocation method is not reasonable if the contribution of property and the corresponding allocation of tax items with respect to the property are made “with a view” to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability. Where the Section 704(c) anti-abuse rule applies, the IRS is permitted to place the taxpayer on a reasonable Section 704(c) method. However, the IRS is not permitted to require a taxpayer to adopt the remedial method.
The IRS identified three requirements for the Section 704(c) anti-abuse rule to apply. The contribution of property and allocation of items with respect thereto must be: “1) made with a view 2) to shifting the tax consequence of the property’s built in gain 3) in a manner that substantially reduces the present value of the partners’ aggregate tax liability.”
The IRS noted that the Section 704(c) regulations do not describe what is required for a contribution of property and allocation of tax items to be made “with a view” to shift the tax consequences with respect to the property. The IRS indicated that the “with a view” standard has a lower threshold than the general partnership anti-abuse rule in Treas. Reg. Sec. 1.701-2(b), which requires a showing that a partnership was formed or availed of in connection with a transaction “a principal purpose of which” is to reduce the partners’ aggregate tax liability.
The IRS explained that, even if a taxpayer has other valid business motives, all that is required to satisfy the “with a view” standard under the Section 704(c) anti-abuse rule is that the proscribed shift in tax consequences be “contemplated” or a “recognized possibility”. The IRS determined that the “with a view” prong of the Section 704(c) anti-abuse rule was satisfied: the domestic partners and foreign partner were related, knew the tax attributes of the other partners, and chose a Section 704(c) method they understood would maximize the tax benefits to the domestic partners.
Ultimately, the IRS concluded that the elements of the Section 704(c) anti-abuse rule were met. The FAA suggests making a curative allocation of the taxable income from the foreign partner to the domestic partners to fully offset the effect of the ceiling rule. Under the IRS’ suggested method, the domestic partners would recognize the built-in gain in the contributed intangibles over their remaining Section 704(b) book amortization period. Also, the FAA confirms that the IRS is not permitted to place the partnership on the remedial allocation method or otherwise require the partnership to create notional items.
The situation in the FAA predates guidance under Section 721(c). A transaction similar to the one described in the FAA, if undertaken today, likely would not present the same opportunity for tax planning through the selection of Section 704(c) methods because regulations under Section 721(c) require use of the remedial allocation method for Section 704(c).
More generally, the FAA sheds light on the Section 704(c) anti-abuse rule. First, the IRS appears to view the “with a view” standard as having a low threshold. Additionally, the FAA also indicates that the IRS might not respect a back-end gain curative allocation if the relevant Section 704(c) property is not intended to be sold.
Grace Kim has more than 20 years of experience in the area of partnership taxation, which includes IRS, law firm and accounting firm positions. Her diversified experience includes working on a broad range of structuring and operational issues in a variety of industries and areas.
Washington DC, Washington DC
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