Close
Close

Ruling clarifies Section 704(c) anti-abuse rule

RFP
Tax Hot Topics newsletter 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.

Contacts:
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

Sarah Barlow
Senior Associate
Washington National Tax Office
T +1 202 521 1505

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.