international jvs feb 2010

8/13/2019 International JVs Feb 2010

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INTERNATIONAL

JOINT VENTURES

by

DAVIDL.FORST

FENWICK

&WEST

LLPWWW.FENWICK.COMFEBRUARY2010
http://www.fenwick.com/http://www.fenwick.com/http://www.fenwick.com/http://www.fenwick.com/http://www.fenwick.com/http://www.fenwick.com/http://www.fenwick.com/


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INTERNATIONAL JOINT VENTURES

TABLE OF CONTENTS

I. Introduction .............................................................................................................1

II. Consequences of Entity Classification ...................................................................1

III. U.S. Partner in a Foreign Partnership .....................................................................2A. General Structuring Considerations ...........................................................2B. The Partnership Agreement ........................................................................3C. Partnership Elections ..................................................................................5D. Partnership Returns .....................................................................................7E. Transfer of Assets to a Foreign Partnership ................................................8

F. Section 704(c) Issues ..................................................................................12G. Dual Consolidated Loss Issue ( 1503(d))..................................................16H. Section 987 Currency Rules........................................................................25I. Foreign Taxes..............................................................................................32J. Allocation and Apportionment of Expenses ...............................................51K. Challenges to Partnership Allocations ........................................................55L. Section 752 Regulations on Disregarded Entities .......................................56M. Sale of CFC by Foreign Partnership-Section 1248 .....................................59N. Section 894..................................................................................................60O. Exit Strategies .............................................................................................61

IV. Partnership with U.S. and Foreign Partners Conducting Business Inside theU.S. .....................................................................................................................63A. In General....................................................................................................63B. Section 1446 Withholding ..........................................................................64C. Foreign Partners Filing U.S. Federal Income Tax Return ..........................68D. Sale or Exchange of Partnership Interest ....................................................69

V. Partnerships with a Foreign Subsidiary as a Partner ...............................................69A. Overview .....................................................................................................69B. Aggregate-Entity-Conduit Treatment .........................................................70C. Background of Anti-Brown Group Regulations .........................................71

D. Foreign Personal Holding Company Income ..............................................73E. Foreign Base Company Sales Income ........................................................77F. Foreign Base Company Services Income ...................................................88G. Notice 2009-7..............................................................................................88H. Section 956..................................................................................................89I. Subpart F Deductions and Losses ...............................................................93J. Section 987..................................................................................................93K. Exit Issues ...................................................................................................94


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David L. ForstFenwick & West LLP

I. INTRODUCTION

This outline discusses the principal federal income tax issues that arise, when a

U.S. corporation establishes a joint venture outside the U.S. with a foreign jointventurer using a non-U.S. entity treated as a partnership for U.S. federal income

tax purposes. It also discusses certain issues when a U.S. corporation is a partner

with one or more foreign partners in a domestic joint venture and where acontrolled foreign corporation (CFC) is a partner in a foreign entity treated as a

partnership for U.S. federal income tax purposes.

II. CONSEQUENCES OF ENTITY CLASSIFICATION

Among the U.S. tax issues which depend on whether the foreign entity constitutesa branch, a partnership or a corporation for U.S. tax purposes are:

A. The taxation of contributions of property, including intangibles, by a U.S.

person to the foreign entity. See 367, 351 and 721.

B. The flow-through of early tax losses and subsequent taxable income to the

owners if the entity is a partnership or branch 704(b), (c) and (d);

together with possible application of the dual consolidated loss rules of 1503(d); the branch loss recapture rules of 367(a)(3)(C), and the

overall foreign loss rules of 904(f).

C. Possible deferral of U.S. tax on the entitys profits if the entity is a

corporation.

D. Application of the U.S. Subpart F and PFIC rules depends on whether the

entity is a corporation or a partnership. See, e.g.,Treas. Reg. 1.952-1(g)

(the anti-Brown Group regulations)

E. The effective application of 482.

F. The nature (direct or indirect), availability and calculation of foreign tax

credits;

G. Tax consequences of current distributions. See 731, 987, 301.

H. Tax consequences of a disposition or liquidation of the entity. See 731,

331, 332, 336, 337, 367(b), 1248.

I. Tax consequences of certain taxable acquisitions. See 338 and 754/743.

J. Application of foreign currency rules of 985-989.


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K. Application of U.S. withholding tax rules. 1441-1446. Note in

particular a partnerships obligation to withhold on the distributive share

of its foreign partners U.S. effectively connected income. 1446.

L. Reporting requirements. Forms 5471 and 8865; 6038, 6038B, 6046A,and 6031(e).

III. U.S. PARTNER IN A FOREIGN PARTNERSHIP

A. General Structuring Considerations

1. This structure would involve either a U.S. person investing directlyin a foreign partnership or a U.S. person investing directly in aforeign limited company that makes a check-the-box election to betreated as a partnership. It also could involve a U.S. personholding a foreign partnership interest through a foreign entity thatmakes a check-the-box election to be treated as fiscally

transparent.

2. U.S. partners could find this structure attractive for a number ofreasons

(a) Losses flow through into the U.S. return.

(b) Foreign tax credits flow through to the U.S. return. Theflow through of credits might be particularly important ifthe joint venture entity or a foreign holding company weretreated as a corporation and could not remit a dividend due

to a lack of earnings and profits.

(c) A partnership permits much more flexibility in how thepartners structure their business deal. For example, thepartners can specially allocate tax items, includingdeductions and credits. This is not possible in a corporatestructure. See Treas. Reg. 1.902-1(a)(9)(iv) and (10)(ii)(forbidding the special allocation of earnings and taxes toparticular shareholders).

(d) It is easier to transfer property to a foreign partnership, asthe 367 outbound transfer rules do not apply. In

particular 367(d) does not apply to the transfer ofintellectual property to a foreign partnership. Further, if thepartnership pays the transferor-partner a royalty, thepartnerships royalty deduction could be specially allocatedto the transferor-partner.


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(e) The distribution of property from a partnership to a partnergenerally is tax free, the principal exception being if theamount of cash or cash equivalents distributed to a partnerexceeds the partners adjusted basis in its partnershipinterest. 731(a)(1).

(f) The liquidation of a partnership generally is tax free, againthe principal exception being if the amount of cash or cashequivalents distributed to a partner exceeds that partnersbasis in its partnership interest. 731(a)(1).

(g) It is generally less tax costly to convert a partnership to acorporation than vice versa. In the international context,due consideration must be given to 367 issues on anincorporation, for example the branch loss recapture rule ifthe partnership incurred losses that flowed through to theU.S. return (Treas. Reg. 1.367(a)-6T), and the outbound

transfer of intangibles ( 367(d)).

3. A tax planner obviously will need to take into accountcountervailing considerations, such as income of the joint ventureflowing through to the U.S. return, deductions that flow throughbeing characterized as foreign source deductions, the dualconsolidated loss rules ( 1503), the overall foreign loss rules( 904(f)), 987 currency issues, and limitation on deduction ofpartnership losses ( 704(d)).

4. A U.S. taxpayer who desires to defer the foreign joint ventures

income from U.S. tax but also conduct the joint venture inpartnership form either could make a reverse check-the-box

election in respect of the joint venture entity (to cause the jointventure entity to be treated as a corporation for U.S. tax purposes)

or form a foreign holding company to hold the joint venture

interest (with due consideration to subpart F and other anti-deferral

provisions).

B. The Partnership Agreement

1. If the partnerships business is conducted principally outside the

U.S., the partnership likely will be an entity organized under aforeign jurisdiction.

2. The U.S. members need to pay careful attention to what will

constitute the partnership agreement. The regulations define a

partnership agreement broadly as the original agreement among the


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partners, whether oral or written, and any modifications thereof.

Treas. Reg. 1.761-1(c). See alsoTreas. Reg. 1.704

1(b)(2)(ii)(h).

3. If the joint venture entity is treated as a corporation under foreignlaw, then its organizational document typically will be its articlesof association, bylaws or the equivalent. Such documents are notpartnership agreements in the traditional sense and will lack manyof the provisions that might be desired by the U.S. partners ormight be required by U.S. tax rules.

4. Even if the joint venture entity is treated as a partnership underforeign law, issues that are unique to the U.S. tax rules would needto be addressed.

5. These issues should be addressed up-front, before the transactiondocuments are executed. If a matter is not addressed in the

partnership agreement, then the regulations state that provisionsof local law are considered to constitute part of the agreement.The U.S. partners will want to thoroughly familiarize themselveswith foreign law to the extent that the partnership agreement issilent on any issues that may be important to them. A saferapproach generally is to address all important issues in thepartnership agreement itself.

6. One issue in particular that U.S. partners will want to consider iswhether it is necessary or desirable for the partners to have 704(b) capital accounts and for the partnership agreement to

include capital account maintenance provisions.

(a) Complying with the capital account maintenance provisionsprovides certainty as to the validity of partnership taxallocations.

(b) However, 704(b) capital accounts, which are maintainedunder U.S. tax rules, can add layers of complication to adeal whose economics are reflected through the prism offoreign tax and accounting rules. Further, foreign partners,and particularly those without U.S. tax counsel, might balk

at the partnership agreements inclusion of an unfamiliarand complex set of rules.

(c) Thus, U.S. partners should consider whether themaintenance of capital accounts is necessary or whether itis safe to fall back on the general and more administrable


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partners interest in the partnership test as the means ofgoverning partnership allocations. See Treas. Reg. 1.704-1(b)(3). In particular, it is important to think throughwhether there could be mismatches between allocations anddistributions that are mandated by foreign rules and those

that are mandated by U.S. rules. Any such issues should beaddressed before the partnership agreement is signed andnot before tax returns are filed.

7. There are many other provisions that U.S. partners might want toconsider adding to the partnership agreement, including provisionsgoverningdistributions, including tax liability distributions andliquidating distributions; special allocations of income or loss; theselection of 704(c) methods; how tax controversies are handled;and matters in respect of the transfer of partnership interests (suchas whether the partnership closes its books immediately before thetransfer or pro rates its income in the year of the transfer).Obviously, any such matters would need to pass muster under locallaw.

C. Partnership Elections

1. The importance of addressing issues up-front is particularly acutein the case of partnership elections. U.S. partners will want toretain control over all U.S. tax-related elections and should makesure that this issue is addressed in the partnerships organizationaldocuments. Elections that could have a material impact on theU.S. partners include a 195 election to amortize start-up

expenses, a 709 election to amortize organizational expenses,and a 754 election to adjust the basis of partnership property.

2. Section 703(b) requires any election affecting the computation oftaxable income derived from a partnership to be made by thepartnership itself. A foreign partnership that does not have U.S.source gross income or U.S. effectively connected gross income isnot required to file a U.S. federal income tax return. Nevertheless,a foreign partnership must file a return for the partnershipselections to be effective. Atlantic Veneer Corporation v.Commissioner, 812 F. 2d 158 (4thCir. 1987).

3. The regulations state that a return filed for the purposes of makingelections must be signed either by each partner that is a partner atthe time the election is made, or any partner who is authorizedunder local law or the partnerships organizational documents tomake the election. Treas. Reg. 1.6031(a)-1(b)(5). It is important


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for a number of reasons that the partnership agreement authorizes apartner to file a return for the purpose of making elections. Suchan authorization avoids any issues with getting all partners to signthe U.S. partnership return. A return filed by a partner who isauthorized to do so need not be a full-fledged return, but simply

needs to state the name and address of the partnership and theelection(s) being made. As further discussed below, a return filedby a partner who is authorized to do sois not treated as a returnunder 6031(a). Partners likely will not want to rely on local lawto take care of such an important issue.

4. While a U.S. Federal return need not be filed for the partnershipentity to make a check-the-box election, the check-the-boxregulations have a similar requirement. These regulations statethat the requisite form (Form 8832) must be signed either by eachmember of the electing entity who is an owner at the time theelection is filed or any officer, manager or member of the electingentity who is authorized under local law or the entitysorganizational documents to make the election. Treas. Reg. 301.7701-3(c)(1)(i). Thus, the partnership agreement also shouldauthorize an appropriate person or persons to make check-the-boxelections. This authorization also should apply to cases where theentity makes a check-the-box election on behalf of a subsidiary.

5. A partnerships making of a 195 election to amortize start-upexpenditures can be very important.

(a) A taxpayer must capitalize start-up expenditures, unless the

taxpayer makes an election under 195(b) to amortize suchexpenditures over 180 months beginning in the month inwhich an active trade or business begins. A 195(b)election cannot be made later than the time for filing the taxreturn for the year in which the trade or business begins. 195(d).

(b) Costs of expansion that would be deductible as an ordinaryand necessary business expense under 162 if incurred bya partner, may a start-up expenditure if incurred by a newlyformed partnership, thus necessitating a 195(b) election.

Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521,(1979), aff'd,633 F.2d 512 (7th Cir. 1980).

(c) "Start-up expenditures" are defined to mean any amountspaid or incurred in connection with:


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(i) investigating the creation or acquisition of an activetrade or business,

(ii) creating an active trade or business, or

(iii) any activity engaged in for profit and for theproduction of income, before the day on which theactive trade or business begins, in anticipation ofsuch activity becoming an active trade or business,and which if paid or incurred in connection with theoperation of an existing active trade or business (inthe same field as the trade or business referred toabove) would be allowable as a deduction for thetaxable year in which paid or incurred. 195(c)(1).

(d) "Start-up expenditures" do not include amounts deductibleunder 163(a) (interest), 164 (taxes), or 174 (research

or experimental expenditures). Id.

(e) There is no clear standard for determining when an activetrade or business begins, but the consensus of theauthorities suggests that a trade or business begins whenthe business earns revenue. SeeRichmond TelevisionCorp. v.United States, 345 F.2d 901 (4th Cir. 1965) (ataxpayer has not engaged in carrying on any trade orbusiness within the intent of 162(a) until such time as thebusiness has begun to function as a going concern andperformed those activities for which it was organized);

Kennedy v. Commissioner, 32 T.C.M. 52 (1973), (taxpayerheld not to be "carrying on" a trade or business under 162(a) until the date he first opened the pharmacy doorsto the public, notwithstanding the fact that he was legallycapable of filling prescriptions at an earlier date); and LTR9331001 (April 23, 1993) ( 195 applied to opening of firstretail store by manufacturer/ wholesale distributor; andcosts of opening subsequent retail stores were not subject to 195).

D. Partnership Returns

1. A foreign partnership that does not have U.S. source gross incomeor U.S. effectively connected gross income is not required to file aU.S. return.


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(a) Section 6231(a)(1)(A) defines the term partnership toinclude any partnership that is required to file a U.S.Federal income tax return pursuant to 6031(a).

(b) Section 6031(e), which was enacted as part of the TaxpayerRelief Act of 1997, exempted foreign partnerships withoutU.S. source gross income or U.S. effectively connectedincome from being required to file a U.S. Federal incometax return under 6031(a).

2. A foreign partnership that is not required to file, and does not file,a U.S. federal income tax return is exempted from the TEFRAaudit rules and procedures, which generally consist of a separateaudit of the partnership return in respect of partnership items andspecific procedures related thereto.

3. A U.S. partnership return filed by one partner with authority to do

so solely for the purpose of making partnership-level electionsdoes not cause a foreign partnership to be characterized as beingrequired to file a U.S. income tax return under 6031(a).Therefore, a partnership that files such a return is not subject to theTEFRA rules. Treas. Reg. 1.6031(a)-1(b)(5).

4. On the other hand, a foreign partnership with no U.S. source grossincome or effectively connected income that files a return (eventhough it is not required to do so) would appear to be subject to theTEFRA rules. See 6233, andFSA 200149019 (Dec. 7, 2001).Thus, it appears that a foreign partnership that otherwise is not

subject to the TEFRA rules may effectively elect into the TEFRArules by filing a U.S. federal income tax return. It would seemunnecessary for a partnership to do so.

E. Transfer of Assets to a Foreign Partnership

1. As a general matter no gain or loss is recognized on a transfer of

property to a foreign partnership in exchange for a partnershipinterest. 721

2. Sections 721(c), (d) and 367(d)(3) authorize the Service to writeregulations treating certain transfers of property to a partnershipwith foreign partners as taxable.

(a) These rules potentially apply both to domestic and foreignpartnerships. The salient factor is whether income or gainderived from property contributed by a U.S. partner couldbe allocated to a foreign partner. The purpose of these


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rules, which are linked to the 367(a) outbound transferregime, is to impose an exit tax on appreciated tangibleproperty and intangible property (whether appreciated ornot) that leaves the U.S. taxing jurisdiction.

(b) The Service has not written regulations under theseprovisions, and therefore they presently are not operative.Further, regulations seem largely unnecessary since 704(c), although not specifically written in theinternational context, largely takes care of these policyconcerns. If the Service ever writes regulations,presumably they simply would serve as a backstop to 704(c). (Seediscussion of 704(c) in section III.E.below)

3. The transfer of rights to intellectual property to a partnership raisesissues in respect of whether the rights qualify as property, and

thus is entitled to the protection of 721. Most of the authority inthis area is in the context of transfers to corporations and 351.Although the statutory schemes of 351 and 721 are not entirelyanalogous, precedents under one section should be relevant to theother. SeeUnited States v. Stafford, 727 F.2d 1043 (11th Cir.1984).

(a) The Service's published position with respect to transfers ofknow-how or patents is that a transfer will constitute atransfer of property within the meaning of 351 only if in ataxable transaction it would constitute a "sale or exchange"

of property rather than a license for purposes ofdetermining gain or loss. SeeRev. Rul. 69-156, 1969-1C.B. 101; Rev. Rul. 64-56, C.B. 1964-1 (Part I), 133. A"sale or exchange" requires a transfer of all substantialrights.

(b) The position of decided case law differs from that of theService. InE.I. Du Pont de Nemours & Co. v. UnitedStates, 471 F.2d 1211 (Ct. Cl. 1973), the Court of Claimsconsidered whether a non-exclusive patent license to awholly-owned foreign subsidiary qualified under 351 of

the Code. The taxpayer granted to its wholly-ownedsubsidiary a royalty-free, non-exclusive license to make,use and sell three of its herbicides under French patents forthe remaining life of the French patents in exchange forstock valued at approximately $400,000. The court heldthat the transfer of the nonexclusive license qualified under


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351 even though the transaction would not be a sale orexchange under 1221 or 1231. The court noted that 351 was premised on the fact that the taxpayer continuesthe business merely in a different form, whereas the capitalgains provision determines whether there has been a full

and complete divestiture of the taxpayer's interest in theproperty. Thus, it would be anomalous to require morecomplete divestiture under 351 to obtain non-recognitionwhen the purpose for non-recognition is retention of controlof the assets transferred in corporate form. Consequently,the court held that the transfer qualified under 351. Afterdismissing the government's application of capital gainsconcepts in the context of 351, the court went on todetermine that the nonexclusive license constituted"property" and that the grant of the license in return forstock constituted a transfer in exchange for stock for

purposes of 351. SeealsoH. B. Zachry Co. v.Commissioner, 49 T.C. 73 (1967) (cited inDu Pont), wherethe Tax Court determined that the transfer of a carved outoil payment was a transfer of property for 351. The TaxCourt also rejected the Service's argument that thetransaction had to qualify as a sale or exchange for capitalgains purposes to qualify under 351.

(c) Subsequent toDu Pont, the Service issued three GCMs inwhich it acknowledged that the court inDu Pontreachedthe right result. Consequently, the GCMs state that theService's position is no longer that all substantial rights toknow-how or patents have to be transferred in order toqualify under 351. The GCMs recommended that theService publish rulings indicating that the Service wouldfollowDu Pont. SeeGCM 36922 (November 16, 1976);GCM 37178 (June 24, 1977); GCM 38114 (September 27,1979). The Service, however, has not issued a revenueruling stating that it will followDu Pont.

(d) With respect to know-how, Rev. Rul. 64-56, 1964-1 (Part I)C.B. 133, states that the Service will recognize know-howand trade secrets as property for purposes of 351. This

category of property includes:

(i) anything qualifying as a secret process or formulawithin the meaning of 861(a) (4) and 862(a)(4);and


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(ii) any other secret information as to a device, process,etc., in the general nature of a patentable inventionwithout regard to whether a patent has been appliedfor and without regard to whether it is patentable inthe patent law sense. Any other information which

is secret will be given consideration as "property"on a case-by-case basis.

(iii) Rev. Rul. 64-56 notes that when know-how hasbeen developed specially for the transferee, thestock received in a 351 exchange may be treatedas payment for services rather than as an exchangeof property for stock. SeealsoRev. Proc. 69-19,1969-2 C.B. 301 which provides guidelines forwhen know-how will be treated as property forpurposes of advance rulings under old 367 and 351. Rev. Proc. 69-19 requires representationsthat the "information" is "original, unique, andnovel," is not disclosed by the product on which it isused or to which it is related, and is "secret in that itis known only by the owner and those confidentialemployees who require the information for use inthe conduct of the activities to which it is relatedand adequate safeguards have been taken to guardthe secret against unauthorized disclosure."

(e) Transfers of rights other than rights in technology.

(i) In Ungar v. Commissioner, 22 T.C.M. 766 (1963),the court held that the transfer of a contract for thepurchase of real property negotiated by thetransferor constituted property for purposes of 351.

(ii) In Stafford,supra, the court held that a contributionby a partner to a partnership of a letter of intent forfinancing from a life insurance company was acontribution of property under 721, even thoughthe letter of intent was not enforceable. Seealso

Mark IV Pictures, Inc. v. Commissioner, 60 T.C.M1171, aff'd, 969 F.2d 669 (8th Cir. 1992) (the factthat partners can demonstrate that they wereseparately and adequately paid for their services,tends to show that they received their partnershipinterest in exchange for the contribution of


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property; in this case the taxpayer failed to showadequate compensation).

(iii) InHospital Corporation of America v.Commissioner, 81 T.C. 520 (1983), the Tax Courtheld that the diversion of a corporate opportunity tonegotiate and perform a contract was not a transferof property under 351.

(f) The tax treatment of the transfers of intangible property to apartnership can be different if the U.S. transferor receivesonly a profits interest in the Joint Venture and no capitalaccount credit, in exchange for the transfer of intangibleproperty. In this case, even if the transaction does notqualify under 721(a), arguably the U.S. transferor wouldbe taxed only when Joint Venture profits were subsequentlyallocated to it.

4. The reporting requirements of 6038B apply to contributions toforeign partnerships by a U.S. person who, immediately after thecontribution, holds a 10% interest in the partnership, or whotransfers more than $100,000 in value during a 12 month period.Treas. Reg. 1.6038B-2. Reporting is done on Form 8865.

F. Section 704(c) Issues

1. Generally 704(c) and Treas. Reg. 1.704-3 and 4, require anybuilt-in gain or loss in contributed property (i.e., the difference

between the propertys 704(b) book basis and its adjusted taxbasis) to be allocated to the contributing partner upon a subsequentsale or distribution (within 7 years) of the contributed property.Section 737 acts as a backstop to 704(c) when a partnershipdistributes other property to the contributing partner within 7 years.The purpose of 704(c) is to prevent the shifting of taxconsequences among partners with respect to property contributedto a partnership with built-in gain or loss at the time ofcontribution.

2. The regulations under 704(c) prescribe three methods to achieve

this objective. Two such methods (the traditional method withcurative allocations and the remedial method) permit a partnershipto specially allocate items of income or loss that are not generatedby the 704(c) property at issue. For example, if in a two-partnerpartnership, the U.S. partner (USP) contributes property with anadjusted tax basis of $0 and a 704(b) book value of $100, these


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two methods would permit deductions generated by the partnershipfrom other activities or notional deductions to be speciallyallocated to the foreign (FP), and income generated by thepartnership from other activities or notional income to be speciallyallocated to USP as the propertys 704(b) book value depreciates.

The third method (the traditional method) does not permit specialallocations of income or loss not generated by the property at issue,and thus book-tax differences would only be remedied on a laterdisposition (if any book-tax difference exists at that time).

3. The 704(c) regulations contain an anti-abuse rule that can applyif a 704(c) method is selected with a view towards shifting thetax consequences of built-in gain or loss among the partners in amanner that substantially reduces the present value of the partnersaggregate tax liability. Treas. Reg. 1.704-3(a)(10). The anti-abuse rule merits special attention where there are foreign partnersto whom income could be shifted with no U.S. tax consequence tothem. Therefore, U.S. partners need to carefully think through theselection of 704(c) methods if items of property with book-taxdifferences will be contributed to the partnership. These mattersshould be covered in the partnership agreement itself to preventany later confusion amongst the partners and to reduce thepossibility of challenge by the Service.

4. An important issue is whether use of the traditional method wouldpass muster when a U.S. partner contributes built-in gain propertythat is subject to the ceiling rule. This could occur, for example, ifthe U.S. partner contributes zero basis property, such as IP, to the

partnership.

(a) Treas. Reg. 1.704-3(b)(2), Example 2 provides anexample of an unreasonable use of the traditional method inrespect of property subject to the ceiling rule. (The ceilingrule provides that the total income, gain, loss, or deductionallocated to the partners for a taxable year with respect to aproperty cannot exceed the total partnership income, gain,loss, or deduction with respect to that property for thetaxable year. Treas. Reg. 1.704-3(b)(1).)

(b) In this example, partners C and D form a partnership inwhich they agree to allocate tax items 50-50. The examplestates that D has substantial NOL carryovers, but D alsocould be a foreign partner who is not subject to U.S. tax. Ccontributes property with an adjusted tax basis of $1,000and a 704(b) book value of $10,000. The property has


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only one year of tax depreciation remaining at the time ofcontribution. Thus, after one year, both the propertysadjusted tax basis and its 704(b) book value are $0, andaccordingly, no further 704(c) allocation is required inrespect of this property. In the next year the property is

sold, and the partnerships gain is allocated 50-50 amongstC and D (i.e., there is no 704(c) special allocation ofincome to C).

(c) The example states that the use of the traditional method isunreasonable. It states that the interaction of thepartnerships one-year write-off of the entire book value ofthe property and the use of the traditional method results ina shift of $4,000 of the precontribution gain to D (who hassubstantial NOL carryovers). It further states that thetraditional method was used with a view to shifting asignificant amount of taxable income to a partner with alow marginal tax rate (D) and away from a partner with ahigh marginal tax rate (C).

(d) The example provides for a safe harbor against applicationof the anti-abuse rule, stating that the partnerships use ofthe traditional method would not be unreasonable if thepartnership agreement in effect for the year of contributionhad provided that tax gain from the sale of the property (ifany) would always be allocated to C to offset the effect ofthe ceiling rule limitation. The example cites Treas. Reg. 1.704-3(c)(3), which states that a partnership may make

curative allocations in a taxable year to offset the effect ofthe ceiling rule for a prior taxable year if these allocationsare made over a reasonable period of time, such as thepropertys economic life, and are provided for in thepartnership agreement in effect for the year of contribution.

(e) The safe harbor deviates from a strict application of anoverriding principle of the regulations. The regulationsstate that built-in gain (or loss) is reduced by decreases inthe difference between propertys book value and adjustedtax basis. The safe harbor, by contrast, freezes the amount

of built-in gain (or loss) that is subject to the ceiling rule,and this frozen amount is given tax effect at a later date,even though the amount of the propertys book-taxdifference that is subject to the ceiling rule might havedecreased or disappeared by then.


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(f) The regulations provide no other safe harbor in respect ofthe traditional method other than this rather awkwardapplication of 704(c). Does this suggest that apartnership with U.S. and foreign partners should only usethe safe harbor, or abandon the traditional method

altogether, when a U.S. partner contributes property that issubject to the ceiling rule? Certainly the partnership needsto be careful in its use of the traditional method, but thereshould be other ways of avoiding charges of abuse. If not,then a strict application of the traditional method neverwould be permitted under the facts of the example orsimilar facts. The regulations do not state that this is thecase.

(g) Another approach not discussed in the example also wouldappear to be reasonable. If the contributed property in theexample had a $0 adjusted tax basis (as is typically the casewith the transfer of IP, for example), then the partnershipcould have chosen any reasonable depreciation conventionfor 704(b) book purposes. Treas. Reg. 1.704-1(b)(2)(iv)(g)(3) Thus, suppose that the contributedproperty had a $0 adjusted tax basis, and the partnership,rather than depreciating 100% of the propertys 704(b)book value in year 1, had chosen a depreciation conventionthat accurately reflected the propertys remaining economiclife. Accordingly, when the property was sold in year 2, Cwould have been specially allocated a certain amount ofgain under 704(c). This amount would have been lessthan $4,000 (the amount initially subject to the ceilingrule), but if the 704(b) book depreciation conventionreasonably reflected the propertys remaining useful life, itcould be strongly argued that the property was notcontributed to the partnership with a view to shiftingtaxable income. Of course, the partnership would have theburden of proving that the 704(b) depreciation conventionit selected was reasonable. If this approach were nottreated as reasonable, then the traditional method, absentapplication of the safe harbor, would be de factounreasonable under the facts of Example 2 or similar facts.

As stated, the regulations do not state that this is the case.

5. A mirror issue applies if a foreign partner contributes propertysubject to the ceiling rule and the partnership chooses thetraditional method with curative allocations or the remedialmethod. The facts of Treas. Reg. 1.704-3(c)(4), Example 3


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mirror the facts of Treas. Reg. 1.704-3(b)(2), Example 2 exceptthat the partner with NOL carryovers (or for purposes of thisdiscussion, the foreign partner) contributes the 704(c) propertysubject to the ceiling rule; also, the property is not sold. Theexample states that a curative allocation that eliminates the entire

book-tax difference in the first year is not reasonable since thepropertys useful life is longer than one year. The example statesthat curative allocations would be reasonable if they are made overa reasonable period of time, such as over the propertys economiclife, rather than over its remaining cost recovery period.

6. Thus, both a partnerships use of the traditional method when aU.S. partner contributes property subject to the ceiling rule and apartnerships use of the traditional method with curativeallocations or the remedial method when a foreign partnercontributes property subject to the ceiling seem to be reasonable aslong as the amount subject to the ceiling rule is not eliminatedthrough 704(b) book depreciation that outstrips the propertysreasonably expected economic life.

7. Finally, note that 704(c) and the regulations thereunder apply ona property-by-property basis. Treas. Reg. 1.704-3(a)(2).Accordingly, different methods can be applied to different items ofcontributed property. However, the regulations state that themethod or methods selected must be reasonable in light of the factsand circumstances and consistent with the purpose of 704(c).Thus, if both U.S. and foreign partners contribute property that issubject to the ceiling rule, then the partnership needs to be careful

how it picks and chooses its methods.

G. Dual Consolidated Loss Issues ( 1503(d))

1. Overview

(a) New DCL regulations were issued in March 2007. Unlikethe old DCL regulations, which were reserved onpartnership interests, the new regulations provide a numberof specific rules

(b) The baseline rule is that a U.S. taxpayer cannot use a DCLto offset its income. The regulations define DCL broadly,as essentially any NOL of the dual resident corporation or apass-through entity. Treas. Reg. 1.1503(d)-1(b)(5).


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(c) A U.S. taxpayer can use a DCL, however, to offset itsincome, if it makes a domestic use election. Treas. Reg. 1.1503(d)-6(d). The crux of this election is that thetaxpayer must certify that no portion of the losses,expenses, or deductions taken into account in determining

the DCL has been, or will be, used to offset the income ofany other person under the income tax laws of a foreigncountry (foreign use). This is an all or nothing rule,so that if one dollar of the certified DCLs is used to offsetthe income of another person under foreign law, all theDCLs will be disallowed as a deduction.

2. DCLs and Partnership Interests

(a) General rule. A foreign use is not considered to occur ifthe foreign use is solely the result of another personsownership of an interest in a partnership and the allocation

or carry forward of an item of deduction or loss composingsuch DCL as a result of such ownership. Treas. Reg. 1.1503(d)-3(c)(4)(i). See Treas. Reg. 1.1503(d)-7(c)Example 13.

(b) Combined Separate Unit. This rule applies to a DCLattributable to a combined separate unit (see Treas. Reg. 1.1503(d)-1(b)(4)) that includes an individual separateunit to which the general rule described in the aboveparagraph would apply, but for the application of theseparate unit combination rule. In such a case, the general

rule applies to the portion of the DCL of such combinedseparate unit that is attributable, as provided under Treas.Reg. 1.1503(d)-5(c) through (e), to the individualseparate unit that is a component of the combined separateunit. Treas. Reg. 1.1503(d)-3(c)(4)(ii). SeeTreas. Reg. 1.1503(d)-7(c) Example 14.

(c) Reduction in Interest. The general rule described in (a)above does not apply if, at any time following the year inwhich the DCL is incurred, there is more than a de minimisreductionin the domestic owner's percentage interest in the

partnership. In such a case, a foreign use is deemed tooccur at the time the reduction in interest exceeds the deminimis amount. Treas. Reg. 1.1503(d)-3(c)(4)(iii). SeeTreas. Reg. 1.1503(d)-7(c), Example 13.


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A reduction in interest is not treated as de minimis, andtherefore a foreign use is deemed to occur if (A) Duringany 12-month period the domestic owner's percentageinterest in the separate unit is reduced by 10 percent ormore, as determined by reference to the domestic owner's

interest at the beginning of the 12-month period; or (B) atany time the domestic owner's percentage interest in theseparate unit is reduced by 30 percent or more, asdetermined by reference to the domestic owner's interest atthe end of the taxable year in which the DCL was incurred.Treas. Reg. 1.1503(d)-3(c)(5)(ii).

A reduction of a domestic owner's interest in a separate unitincludes a reduction resulting from another personacquiring through sale, exchange, contribution, or othermeans, an interest in the foreign branch or hybrid entity, asapplicable. A reduction may occur either directly orindirectly, including through an interest in a partnership, adisregarded entity, or a grantor trust through which aseparate unit is carried on or owned. In the case of aninterest in a hybrid entity partnership or a separate unit allor a portion of which is carried on or owned through apartnership, an interest in such separate unit (or portion ofsuch separate unit) is determined by reference to theowner's interest in the profits or the capital in the separateunit. In the case of an interest in a hybrid entity grantortrust or a separate unit all or a portion of which is carriedon or owned through a grantor trust, an interest in suchseparate unit (or portion of such separate unit) isdetermined by reference to the domestic owner's share ofthe assets and liabilities of the separate unit. Treas. Reg. 1.1503(d)-3(c)(5)(iii).

Note that this rule could serioucly reduce flexibility in theconduct of international joint ventures. Any dilution in adomestic owners interest (beyond the de minimis amount)would cause a recapture of DCLs. For example, theunilateral contribution of capital by a new or existingforeign partner could give rise to a triggering event. Is this

what Congress intended when it enacted 721 (no gain orloss shall be recognized to a partnership or to any of itspartnersin the case of a contribution of property to thepartnership in exchange for an interest in the partnership)?


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(d) Hybrid entity that is a partnership and partnership throughwhich a domestic owner indirectly owns a separate unit.The adjusted basis of such an interest is adjusted inaccordance with 705 and as follows. The adjusted basis isdecreased for any amount of a DCL that is attributable to

the partnership interest, or separate unit owned indirectlythrough the partnership interest, as applicable, that is notabsorbed as a result of the application of Treas. Reg. 1.1503(d)-4(b) and (c). The adjusted basis, however, isdecreased for the amount of such DCL that is absorbed in acarryover or carryback taxable year. The adjusted basis isincreased for any amount included in income pursuant toTreas. Reg. 1.1503(d)-6(h) as a result of the recapture ofa DCL that was attributable to the interest in the hybridpartnership, or separate unit owned indirectly through thepartnership interest, as applicable. Treas. Reg. 1.1503(d)-

5(g)(2).

(e) Special Rules apply to a Transparent Entity, which isdefined in Treas. Reg. 1.1503(d)-1(b)(16) as an entitythat:

(i) Is not taxable as an association for Federal taxpurposes;

(ii) Is not subject to income tax in a foreign country as acorporation (or otherwise at the entity level) eitheron its worldwide income or on a residence basis;

and

(iii) Is not a pass-through entity under the laws of theapplicable foreign country. For purposes ofapplying the preceding sentence, the applicableforeign country is the foreign country in which therelevant foreign branch separate unit is located, orthe foreign country that subjects the relevant hybridentity (an interest in which is a separate unit) orDRC to an income tax either on its worldwideincome or on a residence basis.

Example. A U.S. limited liability company (LLC)does not elect to be taxed as an association forFederal tax purposes and is not subject to incometax in a foreign country as a corporation (orotherwise at the entity level) either on its worldwide


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income or on a residence basis. The LLC is ownedby a hybrid entity (an interest in which is a separateunit) that is the relevant hybrid entity. Provided theLLC is not treated as a pass-through entity by theapplicable foreign country that subjects the relevant

hybrid entity to an income tax either on itsworldwide income or on a residence basis, the LLCwould qualify as a transparent entity. See alsoTreas. Reg. 1.1503(d)-7(c) Example 26.

(f) See Treas. Reg. 1.1503(d)-5(c) for rules on attributingitems of income, gain, deduction, and loss to interests intransparent entities. The rules applicable for attributingitems to these interests are consistent with the rules forattributing items to hybrid entity separate units.

(g) Any items of income, gain, deduction, and loss that are

attributable to a separate unit or an interest in a transparententity of the DRC are not taken into account in determiningthe DCL of the DRC. Treas. Reg. 1.1503(d)-5(b)(2).

(h) The Preamble to the old DCL regulations states that theService is concerned with abusive double dipping inrespect of special allocations of partnership loss where asingle item of economic loss is used to offset one stream ofincome for U.S. tax purposes and a separate stream ofincome for foreign tax purposes. The Preamble states thatthe Service is considering including within the definition of

DCL a special allocation of a single item of loss to adomestic partner for U.S. tax purposes and to a foreignpartner for foreign tax purposes. T.D. 8434, 1992-2 C.B.240, 243. See alsoFSA 1999-900, 1999 TNT 40-55; andFSA 200221018 (a DCL can be used by another person ifpartnership losses are shared through the making ofallocations of income and expenses that differ between U.S.tax law and foreign tax law). While this statement is notechoed in the Preamble to the new DLC regulations, specialallocations could be subject to scrutiny.

(i) AM 2009-011. In Generic Legal Advice Memo, AM 2009-011 (Oct. 2, 2009), the National Office opined on certainissues related to foreign use of dual consolidated losses.Scenarios 2 and 3 involve partnerships.


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Assumed Facts

(i) USP is a domestic corporation that files a U.S.income tax return on a calendar year basis.

(ii) FEX is an entity organized under the laws ofCountry X that is subject to Country X income taxon its worldwide income. FEX files its Country Xincome tax return on a calendar year basis.

(iii) Under Country X laws, items of deduction or lossincurred by FEX in a taxable year are available tooffset or reduce any item of income or gain incurredby FEX during such taxable year. Country X lawsdo not permit FEX to carry back losses to taxableyears prior to the taxable year in which the losseswere incurred.

(iv) One or more of the deductions or losses taken intoaccount in computing all DCLs are recognized asdeductions or losses under the laws of Country X.

(v) FEX carries on a business operation in Country Xthat, if carried on by a U.S. person, would constitutea foreign branch within the meaning of Treas. Reg. 1.367(a)-6T(g)(1).

(vi) For periods in which FEX is classified as a

partnership or a disregarded entity for federal taxpurposes, USP's interest in FEX constitutes a hybridentity separate unit within the meaning of Treas.Reg. 1.1503(d)-1(b)(4)(i)(B), and USP's indirectinterest in its share of the business operationsconducted by FEX constitutes a foreign branchseparate unit within the meaning of Treas. Reg. 1.1503(d)-1(b)(4)(i)(A). These two individualseparate units are combined and treated as oneseparate unit (FEX Separate Unit).

Scenario 2

Facts

USP has owned 100 percent of the stock of FEX since itsformation on January 1, year 1. Effective as of the date of


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its formation, FEX elected to be treated as a disregardedentity for U.S. tax purposes

A DCL is attributable to the FEX Separate Unit in year 1(Year 1 DCL). USP timely filed a domestic use electionwith respect to the Year 1 DCL and such loss therefore wasincluded in the computation of USP's taxable income foryear 1.

On January 1, year 3, USP sold for cash two percent of itsinterest in FEX to FC, an unrelated foreign corporation.Although this sale resulted in a foreign use of the Year 1DCL as described in Treas. Reg. 1.1503(d)-3(a)(1), it didnot constitute a foreign use because it qualified for the deminimis exception provided under Treas. Reg. 1.1503(d)-3(c)(5).

On June 30, year 3, FC transferred its two percent interestin FEX to FS, a foreign corporation wholly owned by FC.This transfer also resulted in a foreign use of the Year 1DCL as described in Treas. Reg. 1.1503(d)-3(a)(1).

The issue is whether the de minimis exception applies tothe June 30, year 3, transfer of the FEX interest from FC toFS such that no foreign use of the Year 1 DCL isconsidered to occur.

Analysis

The de minimis exception states that no foreign use of aDCL will be considered to occur as a result of an item ofdeduction or loss composing such DCL being madeavailable "solely" as a result of a de minimis reduction ofthe domestic owner's interest in the separate unit. USP'ssale of the two percent interest in FEX to FC is a deminimis reduction of USP's interest in the FEX SeparateUnit, and the resulting foreign use of the Year 1 DCL issolely the result of that reduction. Consequently, the deminimis exception applies and no foreign use is considered

to occur.

FC's subsequent transfer of the two percent interest in FEXto FS does not change this result. Although the transfer alsoresults in a foreign use of the Year 1 DCL as described inTreas. Reg. 1.1503(d)-3(a), this use occurred with respect


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to the same interest in the FEX Separate Unit the sale ofwhich qualified for the de minimis exception (that is, thetwo percent interest sold by USP on January 1, year 3). Asa result, this foreign use is also considered to arise solely asa result of the reduction in USP's interest in the FEX

Separate Unit.

Therefore, the de minimis exception applies and FC'stransfer of the FEX interest to FS does not result in aforeign use of the Year 1 DCL.

Scenario 3:

Facts

USP and USD, an unrelated domestic corporation, formedFEX on January 1, year 3. USP and USD each owned 50

percent of the interests in FEX. Effective as of the date ofits formation, FEX elected to be classified as a partnershipfor federal tax purposes under Treas. Reg. 301.7701-3(a).

A DCL is attributable to the FEX Separate Unit in year 3(Year 3 DCL). USP timely filed a domestic use electionwith respect to the Year 3 DCL and such loss therefore wasincluded in the computation of USP's taxable income foryear 3.

On January 1, Year 5, USP sold for cash 20 percent of its

interest in FEX (a non-de minimis amount per Treas. Reg. 1.1503(d)-3(c)(4)(iii) discussed below) to USD.

The issue is whether the January 1, year 5, sale of the FEXinterest results in a foreign use of the Year 3 DCL pursuantto the last sentence of Treas. Reg. 1.1503(d)-3(c)(4)(iii).

Analysis

Treas. Reg. 1.1503(d)-3(c)(4) provides an exception toforeign use for certain interests in partnerships or grantortrusts ("(c)(4) exception"). The (c)(4) exception applies to a

DCL attributable to an interest in a hybrid entitypartnership or a hybrid entity grantor trust, or to a separateunit owned indirectly through a partnership or grantor trust.

Under this exception, a foreign use will not be consideredto occur if the foreign use is solely the result of anotherperson's ownership of an interest in the partnership or


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grantor trust, as applicable, and the allocation or carryforward of an item of deduction or loss composing the DCLas a result of such ownership. The exception is limited byTreas. Reg. 1.1503(d)-3(c)(4)(iii) ("(c)(4) limitation"),which provides in general that the exception will not apply

if , at any time following the year in which the dualconsolidated loss is incurred, there is more than a deminimis reduction in the domestic owner's percentageinterest in the partnership or grantor trust.

The GLAM states that the (c)(4) limitation can onlyprevent the application of the (c)(4) exception to whatwould otherwise be a foreign use. Neither the (c)(4)limitation nor the (c)(4) exception can cause a foreign usethat does not otherwise occur. This is evident from thegeneral structure of Treas. Reg. 1.1503(d)-3(a), whichindicates that one should first apply the general definitionof foreign use, and then determine whether any of theexceptions apply. The general definition of foreign use ispreceded by the clause "Except as provided in paragraph(c) of this section," which references exceptions to thegeneral definition of foreign use, including the (c)(4)exception. The first sentence of the related provision ofTreas. Reg. 1.1503(d)-3(c)(1) reinforces this principle byindicating that the (c)(4) exception constitutes an exceptionto the general definition of foreign use that only applies ifthere has otherwise been a foreign use.

Thus, according to the Service, prior to analyzing theapplication of the (c)(4) exception and the (c)(4) limitationit must be determined whether there would otherwise be aforeign use. In years 3 and 4 there is no foreign use of theDCL within the meaning of Treas. Reg. 1.1503(d)-3(a).This is the case without regard to the application of the(c)(4) exception. The (c)(4) exception generally applieswhere a foreign use would otherwise occur solely as aresult of another person's ownership of an interest in thepartnership and the allocation or carry forward of an itemof deduction or loss composing the DCL as a result of such

ownership. Because USD is a domestic corporation,however, the allocation or carry forward of an item ofdeduction or loss composing the DCL does not result in aforeign use because the second condition of foreign use,described above, is not satisfied. That is, the item ofincome or gain that is referenced in the first condition of


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offices functional currency and calculate currency gain orloss by reference to these pools.

(b) The basis pool is roughly described as all of the QBUsaccretions to wealth translated into the home officesfunctional currency at a running average exchange rate.When a QBU makes a remittance to the home office, theamount of the remittance is translated into the homeoffices functional currency at the spot rate on the day theremittance is made. Essentially, the value of the remittanceat the spot rate is compared with the value of the remittanceat the running average exchange rate to determine whetherthe taxpayer recognizes 987 gain or loss.

(c) Specifically, the 987 gain or loss under the 1991 ProposedRegulations was the difference between: (i) the amount of aremittance from a branch translated into the taxpayers

functional currency at the spot rate on the date theremittance is made, and (ii) the portion of the basis poolattributable to the remittance. The formula for determiningthe portion of the basis pool attributable to a remittance isas follows:

Amount of remittance (in thefunctional currency)Equity pool balance reducedby prior remittances

XBasis pool reduced byprior remittances

If the QBUs currency on the date of the remittance is

stronger than the running average, the home officerecognizes currency gain, and if the QBUs currency on thedate of the remittance is weaker than the running average,the home office recognizes currency loss. Accordingly,under the proposed regulations every remittance from abranch to the home office potentially, and likely, results inthe recognition of exchange gain or loss.

(d) The 1991 Proposed Regulations reserved on how tocoordinate the 987 rules and the partnership rules.

4. In Notice 2000-20, 2000-14 I.R.B. 851, the Service stated that itwas planning to review and possibly replace the 1991 ProposedRegulations. The Service stated that it and Treasury wereconcerned that the 1991 Proposed Regulations may not have fullyachieved their original goal of providing rules that are


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administrable and result in the recognition of foreign currencygains and losses under the appropriate circumstances.

5. The 2006 Proposed Regulations introduce a regime that differs inmany fundamental respects from the 1991 Proposed Regulations.

6. The 2006 Proposed Regulations depart from the profit and lossmethod of accounting for a QBUs income, gain, deduction, andloss. The profit and loss method was adopted by the 1991Proposed Regulations and is consistent with the statute andlegislative history. Under the 2006 Proposed Regulations anowner must determine its taxable income attributable to a QBUsactivities under a DASDM-like approach, by translating, often atdifferent exchange rates, each item of the QBUs income, gain,deduction, and loss. The value of certain items (e.g., inventory) isdetermined by reference to the exchange rate in effect when theQBU acquired them. As a result, an owner can effectively

recognize currency gain or loss in respect of these items when itannually reports its taxable income or loss attributable to theQBUs activities.

7. The amount of an owners gain or loss on remittances isdetermined by reference neither to the QBUs earnings or capital,methods which Treasury and the Service had previouslyconsidered. Rather, gain or loss on remittances is determined byreference to the QBUs items denominated in (or determined byreference to) the QBUs functional currency that would be 988transactions in the hands of the owner. The owner must track the

amount by which these items fluctuate in value due to exchangerate movements between the owners and the QBUs functionalcurrencies (net unrealized 987 gain or loss).

8. Partnerships are generally treated as aggregates under the 2006Proposed Regulations, and thus the principles of subchapter K aresecondary to 987 in many respects.

9. An individual or a corporation that is a partner in a partnership istreated as an owner of an eligible QBU of the partnership to theextent that it is allocated under Prop. Treas. Reg. 1.987-7 of all

or a portion of the assets and liabilities of the eligible QBU of thepartnership.

(a) The 2006 Proposed Regulations state that a partners shareof the QBUs assets and liabilities is determined in amanner that is consistent with the manner win which the


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partners have agreed to share the economic benefits andburdens (if any) corresponding to the assets and liabilities,taking into account the principles of subchapter K and theregulations thereunder.

(b) This guidance is sketchy. The sharing of the economicbenefits and burdens of assets and liabilities is not always(or even usually) made explicit in the partnershipagreement. For example, suppose two partners agree toshare all partnership items 50-50, except that one partnerreceives an annual allocation of gross income before theremaining items are split evenly. Or suppose that twopartners agree to split all partnership items 50-50, exceptthat one partner contributes all of the initial capital. It isnot clear how partners who enter into these types ofarrangements (which are not uncommon) would determinetheir respective shares of the economic benefits andburdens of partnership assets and liabilities. Would thepartners be treated under the proposed regulations assharing assets and liabilities 50-50, or must the grossincome allocation or initial capital contribution be takeninto account, and if so, how?

10. There is a fundamental conflict between how the 2006 ProposedRegulations seek to apply 987 to remittances from partnershipsand the principles of Subchapter K. The 2006 ProposedRegulations turn every remittance from a 987 partnership to itspartners into a potential, and likely, recognition event. (While the

1991 Proposed Regulations reserved on partnerships, their rules onbranch remittances, if applied to partnerships, would have had thea similar result.) Subchapter K, however, calls for the recognitionof gain or loss on partnership distributions only in limitedcircumstances, principally when the amount of cash or cashequivalents distributed to a partner exceeds the partners adjustedbasis in its partnership interest. 731(a)(1). For a number ofreasons, the coordination of 987 and Subchapter K should deferto Subchapter K.

(a) First, there would be serious issues of practicality and

administerability if 987 operated independently ofSubchapter K. Every distribution from a partnership wouldbe a potential, and likely, recognition event for the U.S.partners. The prospect of tax on every distribution has itsown issues in the context of a wholly owned branch, butthese issues are multiplied in the case of a partnership with


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foreign partners who are unaffected by 987. Forexample, imagine how foreign partners would react to ademand by U.S. partners that the amount of every cashdistribution be adjusted to take into account 987 gain orloss. On too many occasions, this simply would not be

workable, and it would run counter to the Servicesstatement in Notice 2000-20 that it desires rules that areadministrable.

(b) Second, there is an important legal issue. It is by no meansclear that the Service has the legal authority effectively tooverride Subchapter K by treating every partnershipdistribution as a potential, and likely, recognition event.Section 731(a) is explicit that a partner is taxed on adistribution from a partnership only in certain narrowcircumstanceswhen the distribution of money (or moneyequivalents) exceeds the partners adjusted basis in itspartnership interest, or in the case of a loss, only on adistribution in liquidation of the partners interest in thepartnership. Legislative history confirms that Congressintended to tax distributions from partnerships only rarely.

These new distribution rules limit quite narrowlythe area in which gain or loss is recognized upon adistribution. . . . These rules, combined with thenonrecognition of gain or loss upon contribution ofproperty to a partnership, will remove deterrents toproperty being moved in and out of partnerships as

business reasons dictate. Internal Revenue Code of1954 Senate Committee Report, p. 4729.

Unlike the partnership rules, which are clear in theirlanguage and intent, 987 is anything but clear. Section987(3) does not mention partnerships, much less sanctionan override of subchapter K. While the definition of QBUcovers partnerships, the legislative history underlying 987is silent as to partnership distributions and theinterrelationship between 987 and Subchapter K. Indeed,the relevant legislative history does not even use the termpartnership. In this regard, the legislative historyunderlying the 987 remittance rules is under the headingForeign branches. Thus, it is far from clear whetherCongress seriously thought about the effect of the 987remittance rules on Subchapter K, or much less intendedthat 987 effect a radical overhaul of Subchapter K. Seealso J.N. Ledbetter v. U.S., 792 F. 2d 1015 (11th Cir. 1986)


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(regulation under old 1348 held invalid because itconflicted with 707(c)); andZahler v. Commissioner, 684F. 2d 356 (6th Cir. 1982), revg. and remg.T.C.M. 1981-112 (same result); cf. Kampel v. Commissioner, 634 F. 2d708 (2d Cir. 1980), affg.72 T.C. 827 (1979) (same

regulation held to be valid, but without any analysis ordiscussion regarding any conflict between the statute andthe regulation)

(c) Third, there is an inherent double taxation issue when 987operates independently of Subchapter K. The 2006Proposed Regulations create a legal fiction to resolve thisdouble taxation issue. The Proposed Regulations state thatfor purposes of determining a partners basis in itspartnership interest under 705, any 987 gain or lossrecognized by the partner in respect of a 987 QBU heldby a partnership is the partnerships gain or loss. The needto create such a fiction is perhaps another indication that itwould be more appropriate to fit the operation of 987within the rubric of subchapter K rather than superimpose 987 on top of subchapter K.

(d) Given these issues, it would seem to be more sensible to fitthe principles of 987 within the existing framework ofSubchapter K rather than to superimpose the principles 987 onto Subchapter K. This could be accomplishedrather simply. A U.S. partner in a partnership which has afunctional currency other than the dollar could be required

to keep its basis in its partnership interest in dollars underthe principles of 705 with issues of currency translationgoverned by 987. In accordance with the legislativehistory and the proposed regulations underlying 987,every distribution of cash or property from a partnershipcould be translated from the partnerships functionalcurrency into dollars at the spot rate on the date of theremittance. The partnership rules of 731-733 wouldgovern whether and the extent to which gain or loss isrecognized as a result of the distribution.

(i) For example, suppose that USP contributed $100 toa partnership with the Euro as its functionalcurrency at a time when the Euro to dollar exchangerate is 1:$1. Thus, USPs basis in the partnershipwould be $100. Suppose that the Euro appreciatesin value to 3:1, and the partnership distributes 50.


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The partnership would not recognize currency gainsince its functional currency is the Euro. Pursuantto 987, USP would translate the distribution intodollars at the spot rate on the date of thedistribution. Thus, USP would be treated as

receiving $150. USP would recognize $50 of gainpursuant to 731(a)(1), and USPs basis in itspartnership interest would be reduced to zero under 733. The gain should be capital gain. Future cashremittances would result in USP recognizing gain ifits basis in its partnership interest is not increased inthe interim.

(ii) Suppose that if instead of receiving 50 worth ofcash, USP received 50 worth of property.Pursuant to 987, USP would translate thedistribution into dollars at the spot rate on the dateof the distribution, and thus be treated as receiving$150 worth of property. Pursuant to 731, USPwould not recognize gain on the distribution. USPwould take a $100 basis in the property under 732, and its basis in its partnership interest wouldbe reduced to zero under 733.

(iii) As another example, suppose that FP distributes 50in cash,but the value of the Euro declines to 1:$3.In this case under the principles of 987 USPwould be treated as receiving $17 from FP. USP

would not recognize gain or loss under 731, andUSPs basis in FP would decrease from $100 to$83. USP also would not recognize currency loss.

(iv) Similar rules could apply in the context of apartnership termination, again with the rules of 731 applying, as adjusted to reflect currency gainor loss.

(v) This method would be simple, practical,administrable, transparent to foreign partners, and

would fit comfortably within the statutoryframeworks and intent of both 987 andSubchapter K.

11. The 2006 Proposed Regulations also can produce overrides of 721. Somewhat counterintuitively, contributions to a partnership


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could give rise to gain or loss under 987(3). An asset or liabilityis treated as transferred from a 987 QBU if, as a result of anacquisition or disposition of an interest in a partnership or DEholding a 987 QBU, the asset or liability is not reflected on thebooks and records of the 987 QBU. Examples illustrate how this

rule could potentially cause the recognition of gain or loss.

(a) Prop. Treas. Reg. 1.987-2(c)(9), Example 7 states that Xowns 100% of the interests in a disregarded entity (DE1)which conducts a business in a different functionalcurrency from X, and thus is a 987 QBU of X. Ytransfers property to DE1 in exchange for a 50% interest inDE1, and as a result DE1 converts into a partnership underRev. Rul. 99-5, 1999-1 C.B. 434, with X and Y treated ascontributing property to the newly-formed partnership. Theexample states that due to Ys acquisition of a 50 percentinterest in DE1, 50 percent of the historic assets andliabilities of the business cease being reflected on the booksand records of Xs 987 QBU and are treated astransferred from the QBU to X (and also treated astransferred from Y to Ys 987 QBU). Thus, X likely willrecognize gain or loss merely because another personmakes a contribution to DE1. This rule seemingly violates 721(a), which states that no gain or loss is recognized toa partnership or to any of its partnersin the case of acontribution of property to the partnership in exchange foran interest in the partnership (emphasis provided).

(b) Prop. Treas. Reg. 1.987-2(c)(9), Example 5 describes apartnership that is held 50-50 by X and Y. The partnershipholds a 987 QBU and all of its assets are used in thebusiness of the QBU. A new partner, Z, contributes capitalto the partnership in exchange for a 20 percent interest.The cash contributed by Z is not used by the 987 QBU.The Example states that 10 percent of the QBUs assets andliabilities cease being reflected on Xs and Ys QBUs andtherefore are treated as transferred to X and Y. The result,again, is in conflict with 721(a). The Example does notstate the what the result would be if the cash contributed by

Z were used in the QBUs business.

I. Foreign Taxes

1. A partnership is treated as a conduit for foreign tax credit purposes,with each partner deemed to incur its distributive share of taxes


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paid or accrued by the partnership. See 702(a)(6) (stating thateach partner shall take into account separately its distributive shareof the partnerships creditable foreign income taxes described in 901). A partner's distributive share of the partnerships incomegenerally is treated as income in a separate category determined at

the partnership level. Thus, the income should be general basket tothe extent that the partnership is engaged in the active conduct of atrade or business. Treas. Reg. 1.904-5(h)(1). (This look throughrule does not apply in respect of any limited partner or corporate

general partner that owns less than 10% of the value in apartnership, in which case the partners distributive share of the

partnerships income is passive basket income. Treas. Reg.

1.904-5(h)(2)).

2. Allocation of Foreign Taxes

(a) In October 2006 the Service issued final regulations

addressing the allocation by a partnership of creditableforeign taxes. These regulations provide for a safe harborunder which allocations of foreign tax expenditures will berespected.

(b) Unlike the allocation of income, gain, deduction, and lossthe capital account maintenance provisions do not call for apartners capital account to be adjusted by the allocation ofa partnerships tax credits, including foreign tax credits.

Treas. Reg. 1.704-1(b)(2)(iv)(b). See also Treas. Reg. 1.704-1(b)(4)(ii). Therefore, allocations of tax credits

cannot have economic effect. Accordingly, the finalregulations state that tax credits must be allocated inaccordance with the partners respective interests in thepartnership. Treas. Reg. 1.704-1(b)(4)(viii)(a).

(c) The regulations state that an allocation of creditable foreigntax expenditure (CFTE) will be deemed to be inaccordance with the partners interests in the partnership(i.e., will satisfy the safe harbor) if

(i) the CFTE is allocated (whether or not pursuant to

an express provision in the partnership agreement)and reported on the partnership return in proportionto the distributive shares of income to which theCFTE relates; and


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(ii) Allocations of all other partnership items that, in theaggregate, have a material effect on the amount ofCFTEs allocated to a partner are valid. Treas. Reg. 1.704-1(b)(4)(viii)(a)(1)and (2).

(d) Comments on the Safe Harbor

(i) The final regulations remove the requirement in thetemporary regulations that to qualify for the safeharbor, the partnership must maintain capitalaccounts in accordance with Treas. Reg. 1.704-1(b)(2)(iv). This is helpful in the internationalcontext, where the maintenance of capital accountoften is not necessary and could add undesiredcomplication to the deal. Seediscussion of thisissue at III.B.6 of this outline.

(ii) The preamble states that only in unusualcircumstances (such as where CFTEs are deductedand not credited) will allocations that fail to satisfythe safe harbor be in accordance with the partnersinterest in the partnership. Therefore, for practicalpurposes, the safe harbor appears to be the rule.

(iii) Special allocations of CFTEs are premittedprovided that the specially allocated CFTEs areallocated in the same proportion as the income towhich the CFTEs relate.

(iv) The requirement to allocate CFTEs in accordancewith net income could produce distortions wherethe partners economic deal is to share expenses in aratio different from the ratio in which they end upsharing net income (for example, in the case of agross income allocation).

(A) Treas. Reg. 1.704-1(b)(5), Example 25,describes partnership between A and Bwhere all items are allocated 50/50, with the

single exception being that the first $100Kof gross income each year is allocated to Aas a return on excess capital contributed byA. The example states that in 2007 thepartnership earns $300K of gross income,has $100K of deductible expense, and pays


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$40K of foreign tax. Accordingly, A isallocated $150K of the partnerships pretaxincome and B is allocated $50K of thepartnerships pretax income. Because allpartnership items are allocated equally

(except for the gross income allocation), Aand B are each allocated $20K of CFTE.The example states that the CFTEs must bereallocated in the same ratio as thepartnerships net income, or $30K to A and$10K to B.

(B) The example further states that if thereallocation of CFTEs causes the partnerscapital accounts not to reflect their economicarrangement, the partners may need toreallocate other partnership items to ensurethat the tax consequences of thepartnerships allocations are consistent withthe economic arrangement over the term ofthe partnership. It states that the Servicewill not reallocate other partnership itemsafter the reallocation of CFTEs.

(C) This seems to be an example of an anti-abuse rule having an overinclusive, andunwarranted, effect, particularly on jointventures between unrelated partners.

Assuming A and B in the example areunrelated and their deal motivated bybusiness considerations, foreign taxexpenses should be allocated in the sameproportion as all other partnership expenses.The result mandated by the regulationscauses one partner (A, in the example) to beallocated more foreign taxes (and moreforeign tax credits) than A bears the burdenof. If A were a U.S. person, A would reap awindfall. If B were a U.S. person, B would

suffer a needless detriment.

(D) The example also states that the result wouldbe the same if the preferred gross incomeallocation wee a 707(c) guaranteedpayment.


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(d) A creditable foreign tax expenditure is defined as aforeign tax paid or accrued by a partnership that is eligiblefor a credit under section 901(a) or an applicable U.S.income tax treaty. A foreign tax is a CFTE without regardto whether a partner receiving an allocation of such foreign

tax elects to claim a credit for such tax. Foreign taxes paidor accrued by a partner with respect to a distributive shareof partnership income, and foreign taxes deemed paidunder section 902 or 960 are not taxes paid or accrued by apartnership and, therefore, are not CFTEs subject to therules of this section. Treas. Reg. 1.704-1(b)(4)(viii)(b).

(e) A CFTE category is a category of net income (or loss)attributable to one or more activities of the partnership.Net income (or loss) from all the partnership's activities isincluded in a single CFTE category unless the allocation ofnet income (or loss) from one or more activities differsfrom the allocation of net income (or loss) from otheractivities, in which case income from each activity or groupof activities that is subject to a different allocation is treatedas net income (or loss) in a separate CFTE category. Treas.Reg. 1.704-1(b)(4)(viii)(c)(2)(i). Thus, if a partnershipagreement does not have special allocations, then the CFTEallocation rules will not be relevant. For example, a foreignpartnership which is treated as a corporation for local lawpurposes likely will not need to be concerned with theseallocation rules.

(i) Different allocations of net income (or loss)generally will result from provisions of thepartnership agreement providing for differentsharing ratios for net income (or loss) from separateactivities. See Treas. Reg. 1.704-1(b)(5),Example 21. Different allocations of net income (orloss) from separate activities generally will alsoresult if any partnership item is shared in a differentratio than any other partnership item. A guaranteedpayment described Treas Reg. 1.704-1(b)(4)(viii)(c)(3)(ii), gross income allocation, or

other preferential allocation will result in differentallocations of net income (or loss) from separateactivities only if the amount of the payment or theallocation is determined by reference to incomefrom less than all of the partnership's activities. Apartnership item does not include any item that is


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excluded from income attributable to an activitypursuant to the second sentence of Treas. Reg. 1.704-1(b)(4)(viii)(c)(3)(ii)(relating to allocationsor payments that result in a deduction under foreignlaw).

(ii) Whether a partnership has one or more activities,and the scope of each activity, is determined in areasonable manner taking into account all the factsand circumstances. The principal consideration iswhether the proposed determination has the effectof separating CFTEs from the related foreignincome. Accordingly, relevant considerationsinclude whether the partnership conducts businessin more than one geographic location or throughmore than one entity or branch, and whether certaintypes of income are exempt from foreign tax orsubject to preferential foreign tax treatment. Inaddition, income from a divisible part of a singleactivity shall be treated as income from a separateactivity if necessary to prevent separating CFTEsfrom the related foreign income. The partnership'sactivities must be determined consistently from yearto year absent a material change in facts andcircumstances.

(f) The net income in a CFTE category means the net incomefor U.S. Federal income tax purposes, determined by taking

into account all partnership items attributable to therelevant activity or group of activities, including items ofgross income, gain, loss, deduction, and expense and itemsallocated pursuant to section 704(c) (including reverse 704(c) allocations). Treas. Reg. 1.704-1(b)(4)(viii)(c)(3).

(i) The items of gross income attributable to an activityis determined in a consistent manner under anyreasonable method taking into account all the factsand circumstances.

(ii) Expenses, losses or other deductions are allocatedand apportioned to gross income attributable to anactivity in accordance with the rules of Treas. Reg. 1.861-8 and 1.861-8T. Under these rules, if anexpense, loss or other deduction is allocated to


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gross income from more than one activity, suchexpense, loss or deduction must be apportionedamong each such activity using a reasonablemethod that reflects to a reasonably close extent thefactual relationship between the deduction and the

gross income from such activities. See Treas. Reg. 1.861-8T(c). For purposes of determining netincome in a CFTE category, the partnership'sinterest expense and research and experimentalexpenditures described in section 174 may beallocated and apportioned under any reasonablemethod, including but not limited to the methodsprescribed in Treas. Reg. 1.861-9 through 1.861-13T (interest expense) and 1.

international jvs feb 2010

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