The IRS and Treasury Department recently issued temporary regulations (T.D. 9814
) and, by cross-reference, proposed regulations (REG-127203-15
), concerning certain transfers of appreciated property by U.S. persons to partnerships having one or more foreign partners related to the transferor.
The temporary regulations generally adopt, with some modifications, the rules that were described in Notice 2015-54
, which announced the government’s intention to issue regulations under Section 721(c) to ensure that when a U.S. person transfers certain property to a partnership that has foreign partners, income or gain attributable to the property would be taken into account by the transferor either immediately or periodically. The notice also announced forthcoming amendments to Treas. Reg. Sec. 1.482-7 regarding the application of certain rules (currently applicable to cost sharing arrangements) to controlled transactions involving partnerships. The new guidance does not include guidance under Section 482.
This guidance may significantly affect certain taxpayers considering transfers of appreciated assets, particularly intangibles, to partnerships (foreign or domestic) with foreign related partners. Taxpayers considering such transfers should carefully evaluate the applicability and impact of these temporary regulations.
Background of Notice 2015-54
Under Notice 2015-54, Section 721(a) will not apply, and immediate gain recognition is required, when a U.S. person (a U.S. Transferor) transfers certain property (defined in the notice as Section 721(c) Property) to a foreign or domestic partnership (a Section 721(c) Partnership), unless the requirements of a new method concerning partnership allocations (the Gain Deferral Method) are met. For a summary of the notice, click here.
Though the temporary regulations generally incorporate the rules in the notice, there are several significant changes that are noteworthy and require a taxpayer to carefully consider the regulations’ impact.
Significant changes in the temporary regulations
Regarding ownership thresholds, under the temporary regulations, the definition of a Section 721(c) partnership now contains a higher ownership threshold (80% or more) than in the notice (more than 50%). Under the temporary regulations, a partnership 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 (1) a related foreign person with respect to the U.S. transferor is a direct or indirect partner in the partnership, and (2) the U.S. transferor and related persons own 80 percent or more of the interests in partnership capital, profits, deductions or losses.
Regarding technical terminations, under the temporary regulations, a technical termination of a partnership under Section 708(b)(1)(B) will not cause a partnership that is not a Section 721(c) Partnership to become a Section 721(c) Partnership. Similarly, a recapitalization, or other change in form, identity or place of organization, will not cause a partnership to become a Section 721(c) Partnership.
For purposes of determining if a lower tier partnership (to which an upper-tier partnership that has a U.S. transferor as a direct or indirect partner contributes property) is a Section 721(c) Partnership, the U.S. transferor will be 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. Absent application of the gain deferral method by the lower-tier partnership to the entire property, and by the upper-tier partnership to the partnership interest in the lower-tier partnership, the upper-tier partnership will recognize the entire built-in gain in the Section 721(c).
Gain deferral method
The temporary regulations include numerous changes to the gain deferral method, with a notable one being that should be applied on a property-by-property basis. Accordingly, a Section 721(c) Partnership may choose not to apply the gain deferral method to all of its Section 721(c) Property. Importantly, the requirements for applying the gain deferral method are modified in the regulations as follows:
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
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
Procedural and reporting requirements are satisfied
The U.S. transferor extends the period of limitations on assessment of tax
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 a partnership look-through rule in the temporary regulations
The temporary regulations address comments concerning application of the consistent allocation method. For example, certain regulatory allocations are deemed to satisfy the consistent allocation method, as long as the allocation in question is an allocation of income, or gain to the U.S. transferor or an allocation of deduction or loss to a partner other than the U.S. transferor.
Regarding the extension of the period of limitations, in addition to the U.S. transferor being required to extend the period of limitations on all items related to property subject to the gain deferral method through the end of the eighth full tax year following the contribution, a U.S. transferor also must extend the period of limitations for gain recognized under Section 721(c) with respect to any Section 721(c) Property contributed to the Section 721(c) Partnership through the end of the fifth tax year following the contribution if the property is contributed within five full years after a gain deferral contribution (defined in the temporary regulations as a contribution of Section 721(c) Property to a Section 721(c) Partnership with respect to which the gain is deferred under the gain deferral method).
The temporary regulations include specific provisions for applying the remedial allocation method in the case of property giving rise to effectively connected income and intangibles described in Section 197(f)(9) (i.e.,
The temporary regulations also address acceleration of the built-in gain on Section 721(c) Property. Failure to comply with one of the requirements of the gain deferral method as applied to a Section 721(c) Property is an acceleration event only with respect to that property (reflecting a property-by-property application). Acceleration will not occur solely as a result of a failure to comply with a procedural or reporting requirement so long as the failure is not willful and relief is sought. The temporary regulations set forth various exceptions to acceleration, which exceptions relate to events (e.g.,
certain incorporations of a Section 721(c) Partnership or certain distributions of Section 721(c) Property) that cause the gain deferral method to no longer apply, or where a successor event (e.g.,
a technical termination of a Section 721(c) Partnership, a domestic corporation becomes a successor U.S. transferor or a partnership becomes a successor Section 721(c) Partnership) allows for the continued application of the gain deferral method. Additionally, the regulations provide for partial acceleration events.
The temporary regulations also address the application of the gain deferral method to tiered partnership situations, employing 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 more detailed reporting rules than in the notice, which had 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. Notably, with regard to reporting and procedural requirements for the year of the gain deferral contribution, the temporary regulations implement rules described in the notice in a manner consistent with the approach in regulations under Sections 367(a) and 6038B that were issued in 2014 (T.D. 9704
The temporary regulations’ applicability date generally relates back to the issuance of the notice, which itself was generally effective for transfers made on or after Aug. 6, 2015. The notice also applied to certain transfers made prior to that date if the transfer resulted from an entity classification election made under Treas. Reg. Sec. 301.7701-3 that was filed on or after Aug. 6, 2015, and that was effective on or before that date.
Additionally, the new rules, including any substantive changes to the rules described in the notice, apply to contributions occurring on or after Jan. 18, 2017, or to contributions occurring before Jan. 18, 2017, resulting from an entity classification election made under Treas. Reg. Sec. 301.7701-3 that was filed on or after Jan. 18, 2017. Taxpayers may elect to apply the new rules and substantive changes to the rules described in the notice to a contribution occurring on or after the general applicability date. The temporary regulations expire on Jan. 17, 2020. These temporary regulations, having been issued and published prior to the freeze on regulations imposed by the new Trump administration, are not subject any required withdrawal or review.
The temporary regulations reflect recognition that the notice, with its “more than 50%” test for a Section 721(c) Partnership, potentially captured an overly broad group of partnership situations. The higher level test (80%) is welcome relief. However, even the new test could include situations in which the foreign related partner’s ownership is relatively small. Thus, the temporary regulations could be applicable to a fairly wide range of situations. Given the potential coverage of the guidance, it is important to evaluate in each property contribution situation whether the temporary regulations might apply.
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Partner, Washington National Tax Office
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