Final and Proposed Regulations Address U.S. Property Held by CFCs in Transactions Involving Partnerships
By David Makso & James Grace
On November 3, 2016, the Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “IRS”) issued final regulations under sections 954 and 956 of the Internal Revenue Code of 1986, as amended (the “Code”), which clarify the method for determining the amount of U.S. property held by controlled foreign corporations (“CFCs”) in transactions involving partnerships (the “Final Regulations”).
A U.S. shareholder
The Anti-Avoidance Rule
Prior to the 2015 Temporary Regulations, the anti-avoidance rule under Treas. Reg. §1.956-1T(b)(4) provided that a CFC would be considered to hold indirectly investments in U.S. property acquired by any other foreign corporation that is controlled by the CFC if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) such other foreign corporation is to avoid the application of section 956 of the Code. The Final Regulations adopted the 2015 Temporary Regulations which expanded the scope of the anti-avoidance rule to apply to situations involving funding other than through capital contributions or debt and to apply to transactions involving partnerships that are controlled by a CFC.
The Final Regulations contain a coordination rule which states that the application of the anti-avoidance rule to partnerships will only apply to the extent that the amount of U.S. property that a CFC would be treated as holding under the rule exceeds the amount that it would otherwise be treated as holding under Treas. Reg. §1.956-4(b) (discussed below).
Partnership Property Indirectly Held by a CFC Partner
Limitation on Use of Special Allocations
Under Treas. Reg. §1.956-4(b), a CFC that is a partner in a partnership determines its share of U.S. property held by a partnership in accordance with the CFC’s liquidation value percentage with respect to such partnership, or when relevant, based on a special allocation of income or gain. The 2016 Proposed Regulations provide that a partner’s attributable share will not be determined by reference to special allocations if the partner controls the partnership (e.g., the CFC owns more than 50% of the partnership).
Elimination of Outside Basis Limitation
In 1990, Revenue Ruling 90-112 held that the amount of U.S. property taken into account for purposes of section 956 of the Code when a CFC partner indirectly owns property through a partnership is limited by the CFC’s adjusted basis in the partnership. Treasury and the IRS concluded that this outside basis limitation was not warranted. Revenue Ruling 90-112 has been made obsolete and the outside basis limitation is not reflected in either the Final Regulations or 2016 Proposed Regulations.
Time for Determining the Liquidation Value Percentage
The 2015 Proposed Regulations required the liquidation value percentage to be determined upon formation and subsequently upon the occurrence of specified revaluation events. In response to comments that partners’ relative economic interests in a partnership may change significantly in the absence of a revaluation event, the Final Regulations provide that if a partner’s liquidation value percentage on the first day of the partnership’s taxable year differs from the most recently determined liquidation value percentage by more than 10 percentage points, then the liquidation value percentage must be re-determined on that day.
Obligations of Foreign Partnerships
Consistent Use of Liquidation Value Percentage with Respect to U.S. Property and Obligations
Under the CFC rules, if a CFC makes, or is a guarantor or pledgor with respect to, a loan to a U.S. person, the CFC is treated as making an investment in U.S. property. To ensure that this rule cannot be avoided through the use of foreign partnerships, proposed Treas. Reg. §1.956-4(c) of the 2015 Proposed Regulations provided that an obligation of a foreign partnership would be treated as an obligation of its partners in proportion to the partners’ interest in partnership profits unless certain exceptions apply. Due to the complexity and uncertainty inherent in assessing a partner’s interest in partnership profits, Treasury and the IRS determined that the liquidation value percentage method is preferable for determining a partner’s share of a foreign partnership’s obligations. Thus, the Final Regulations require the consistent use of the liquidation value percentage method for the purposes of determining a partner’s share of partnership property under Treas. Reg. §1.956-4(b) and a partner’s share of partnership obligations under Treas. Reg. §1.956-3(b).
Special Funded Distribution Rule
The Final Regulations also adopt a special funded distribution rule from the 2015 Proposed Regulations that increases the amount of a foreign partnership obligation that is treated as U.S. property when, among other requirements, a CFC makes, or is a guarantor or pledgor with respect to, a loan to a foreign partnership, such proceeds are distributed to a U.S. partner related to the CFC, and the obligation would be treated in whole or in part as U.S. property if held by the CFC.
Comments Concerning Multiple Inclusions
Treasury and the IRS announced that they will continue to study the need to prescribe regulations to limit the aggregate inclusions of a U.S. shareholder with respect to a CFC to the unpaid principal amount of the obligation in situations where multiple CFCs provide a guarantee or pledge assets in support of a single U.S. obligation of a U.S. person.
The Final Regulations are generally applicable for tax years of CFCs ending on or after November 3, 2016. Certain sections of the Final Regulations have earlier effective dates, including the anti-avoidance rule of Treas. Reg. §1.956-1(b), which is applicable for tax years of CFCs ending on or after September 1, 2015.
The 2016 Proposed Regulations will be effective with respect to tax years of CFCs ending on or after their final publication and will only apply with respect to property acquired on or after such date.