IRS applies partnership abuse of entity rule to Section 367(d) transaction

Tax Hot Topics newsletter The IRS recently concluded in CCA 201917007 that a domestic LLC that apparently had foreign partners should not be considered a U.S. person for purposes of Treas. Reg. Sec. 1.367(d)-1T(e)(1), which permits a related U.S. person to succeed to a U.S. transferor’s annual inclusions of income following a transfer of an intangible to a foreign corporation that is subject to Section 367(d).

In arriving at this conclusion, the IRS applied its authority under Treas. Reg. Sec. 1.701-2(e) to treat a domestic partnership as an aggregate of its partners in order to carry out the purposes of Section 367(d). It also concluded that the definition of a domestic partnership in Section 7701(a)(4) was inapplicable.

Under Treas. Reg. Sec.1.367(d)-1T(e)(1), if a U.S. person transfers intangible property subject to Section 367(d) to a foreign corporation in a Section 351 or 361 exchange and, within the useful life of the transferred intangible property, that U.S. transferor subsequently transfers the stock of the transferee foreign corporation to U.S. persons that are related to the transferor, each related U.S. person shall, over the useful life of the property, annually include in gross income a proportionate share of the amount that would have been included in the income of the U.S. transferor (the so-called general rule inclusions).

A transfer to a related U.S. person is an exception to the rule in Section 367(d)(2)(A)(ii)(II) that upon a disposition of the foreign corporation stock the U.S. transferor would be treated as receiving, at the time of the disposition, the amount that would have been received upon a disposition of the property. If the U.S. transferor transfers the stock to one or more related foreign persons, then under Treas. Reg. Sec. 1.367(d)-1T(e)(3), no successor rule apples and the U.S. transferor is to continue to include the income annually as if the subsequent transfer had not occurred.

The facts of the CCA are almost fully redacted, but appear to indicate that a U.S. transferor transferred an intangible to a foreign corporation and then transferred the foreign corporation stock to a related domestic partnership (an LLC), with the objective to have the related domestic partnership be viewed as a related U.S. person under the successor rule in Treas. Reg. Sec. 1.367(d)-1T(e)(1). The annual income was then sought to be allocated by the domestic partnership to foreign persons, resulting in some or all of the annual inclusions not being subject to U.S. tax. Additionally, the U.S. transferor apparently ceased to exist after the transfer to the LLC.

After a comprehensive review of the history of Section 367(d), the IRS analyzed the application of Treas. Reg. Section 1.701-2(e), the abuse of entity provisions of the partnership anti-abuse regulation. Under that regulation, the IRS can treat a partnership as an aggregate of its partners in whole or in part as appropriate to carry out the purpose of any provision of the Code or regulations. However, the IRS cannot assert the abuse of entity rule if:

  1. A provision of the Code or regulations prescribes the treatment of a partnership as an entity, in whole or in part
  2. That treatment and the ultimate tax results, taking into account all the relevant facts and circumstances, are clearly contemplated by that provision.

The IRS explained that it was not clear if the treatment of a partnership as a related person in Treas. Reg. Sec. 1.367(d)-1T(h)(1) was equivalent to prescribing entity treatment, but the second prong of the limitation was clearly not satisfied. It stated that “[t]here is no reasonable argument that Section 367(d) or Treas. Reg. § 1.367(d)-1T(h) clearly contemplated the permanent, complete avoidance of U.S. tax with respect to an outbound transfer of IP under (S)ection 367(d).” It concluded accordingly that it was not prevented from asserting the abuse of entity rule in Treas. Reg. Sec. 1.701-2(e).

Regarding the potential applicability of definitions in Section 7701 for defining a U.S. person for purposes of Treas. Reg. Sec. 1.367(d)-1T(e)(1), the IRS noted that the term “domestic partnership” as used in the Section 367 regulations is determined by reference to Section 7701 generally rather than by specific incorporation of a definition of a domestic partnership.

It explained that Treas. Reg. Sec. 1.367(a)-1(d)(1) defines the term “United States person” by reference to Section 7701(a)(30), which lists “domestic partnership” among other enumerated United States persons. The regulations provide a general cross-reference to Section 7701 for definitions of the enumerated terms, but do not explicitly incorporate the definition of a “domestic partnership” in Section 7701(a)(4). So, although the regulations define a U.S. person to include a domestic partnership, the regulations do not explicitly define what constitutes a domestic partnership.

The IRS stated that the specific purpose implicated by Treas. Reg. Sec. 1.367(d)-1T(e)(1) is to preserve the general rule inclusions if an appropriate related U.S. person is able to step into the shoes of the original transferor and recognize the income attributable to the intangible. It then concluded that treating the domestic partnership here as a successor to the general rule inclusions undermines congressional intent and is manifestly incompatible with the purpose of preserving the general rule inclusions when a related U.S. person remains subject to tax on the income attributable to the intangible.

The IRS also asserts that the definition in Section 7701(a)(4) is manifestly incompatible and thus inapplicable. Additionally, it explains that Treas Reg. Sec. 1.367(d)-1T(e)(3), addressing a subsequent transfer to related foreign persons, cannot apply because the U.S. transferor no longer exists. The CCA demonstrates another instance of applying aggregate principles in a partnership context to combat a perceived abuse. However, given the CCA’s significant redactions in the facts, as well as of portions of the analysis, it is difficult to know the exact context and parameters in which aggregate principles were applied.

Grace Kim
Principal, Partnerships
Washington National Tax Office
T +1 202 521 1590

Jose Carrasco
Senior Manager, Partnerships
Washington National Tax Office
T +1 202 521 1552

Whit Cocanower
Senior Associate
Washington National Tax Office
T +1 202 521 1541

Ryan Nodal
Washington National Tax Office
T +1 803 231 3020

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