- Partnership Tax Allocations: Recent IRS CCA Scrutinizes Purported Loss Allocations of a Non-US Partnership
- October 31, 2017 | Authors: Reginald J. Clark; David A. Roby; H. Karl Zeswitz
- Law Firms: Eversheds Sutherland (US) LLP - Washington Office; Eversheds Sutherland (US) LLP - Atlanta Office
Chief Counsel Advice 201741018 (the CCA), which was released on October 13, 2017, considers the manner in which losses of a non-US partnership should be allocated among the partnership’s US and non-US investors in connection with computing a US investor’s loss on the disposition of its partnership interest.
Under the facts of the CCA, a US corporation (US Parent) and a non-US corporation organized in country 1 (Foreign Parent) determined to enter into a joint venture to conduct activities in country 1. The joint venture was organized as a country 1 limited liability company that elected for US federal tax purposes to be classified as a partnership (the Partnership). The Partnership had two equity owners under country 1 law, including (i) a country 1 corporation owned by US Parent and Foreign Parent (Country 1 Partner) and (ii) a country 2 corporation owned solely by Foreign Parent (Country 2 Partner).
Each of Country 1 Partner and Country 2 Partner contributed capital to the Partnership. Moreover, a US subsidiary of US Parent (US Partner) and Foreign Parent each contributed funds to the Partnership (the Preferred Contributions), which in certain years of the Partnership were “substantial” in relation to the “minimal amounts” contributed to the Partnership by Country 1 Partner and Country 2 Partner in such years. The Preferred Contributions were made in the form of loans under country 1 law; however, US Parent treated the Preferred Contributions as equity for US federal income tax purposes (and the IRS did not dispute the validity of such treatment). Accordingly, the Partnership had four partners for US federal income tax purposes: Country 1 Partner, Country 2 Partner, US Partner and Foreign Parent.
The Preferred Contributions entitled US Partner and Foreign Parent to priority distributions on liquidation of the Partnership because US Partner and Foreign Parent were considered creditors for purposes of country 1 law and because the agreements between the Partnership and US Partner and Foreign Parent gave these partners the first rights to any cash flow. Further, US Partner and Foreign Parent were entitled to fixed payments and variable payments related to the Preferred Contributions. The fixed payments were calculated without regard to the income or cash flow of the Partnership and were treated by US Parent as guaranteed payments for US federal income tax purposes. The guaranteed payments generated deductions to the Partnership, which resulted in Partnership losses that were allocated entirely to Country 1 Partner and Country 2 Partner.
Ultimately, US Parent sold its direct and indirect interests in the Partnership, including the interest held by US Partner, to an affiliate of Foreign Parent. Because the US Partner had not been allocated any Partnership losses, US Partner’s basis in its Partnership interest exceeded US Partner’s amount realized on the sale. Accordingly, US Parent reported a loss on its US consolidated return attributable to the sale of US Partner’s interest.
The CCA considered the extent to which allocations of the Partnership losses to Country 1 Partner and Country 2 Partner were permitted for US federal income tax purposes. Very generally, in order for an allocation of a partnership item to be respected for US federal income tax purposes, the allocation either must have substantial economic effect or must be in accordance with the partners’ interests in the partnership (PIIP).
The CCA concluded that the allocations of the Partnership losses did not have economic effect because none of the requirements of the economic effect test—i.e., that the partnership be required to maintain partner capital accounts in accordance with IRS regulations and to make liquidating distributions to the partners in accordance with their final capital accounts, and that the partners be required on liquidation to restore deficit balances in their capital accounts—were met. As a result, the CCA applied the PIIP test to determine the allocations of the Partnership losses.
In general, the PIIP test considers the manner which the partners have agreed to share the economic benefit or burden (if any) corresponding to the partnership item being allocated, taking into account all facts and circumstances relating to the economic arrangement of the partners.
In the CCA, US Parent argued that, for purposes of applying the PIIP test, Country 2 Partner bore the economic burden of the Partnership losses based on the fact that, under country 1 law, Country 2 Partner was required in certain circumstances to contribute capital to the Partnership to avoid a liquidation of the Partnership. The CCA determined, however, that these additional capital contributions were not required by country 1 law, because the Partnership’s partners could allow the Partnership to liquidate rather than make these additional contributions. The CCA then considered the partners’ rights to distributions on liquidation. In particular, the CCA considered the fact that the Preferred Contributions entitled US Partner and Foreign Parent to priority distribution on liquidation of the Partnership. Based on the preferred distribution rights of US Partner and Foreign Parent, the CCA concluded that Country 1 Partner and Country 2 Partner bore the economic burden of any losses upon liquidation, but only to the extent of the positive balances in the capital accounts of Country 1 Partner and Country 2 Partner (which the IRS computed, presumably under the IRS regulations concerning the economic effect test, during the audit of US Parent). Because US Partner and Foreign Parent bore the economic burden of any losses in excess of the capital accounts of Country 1 Partner and Country 2 Partner, any such excess losses were required under the PIIP test to be allocated to US Partner and Foreign Parent. Thus, the CCA concluded that part of the Partnership losses that were originally allocated to Country 1 Partner and Country 2 Partner were required to be reallocated to US Partner and Foreign Parent, thereby reducing US Partner’s loss on the disposition of its Partnership interest.
Eversheds Sutherland Observations:
- Many partnerships allocate partnership tax items using a “target allocation” methodology. In general, under this methodology, allocations are made to the partners in a manner that results, to the extent possible, in each partner’s capital account (as computed under the IRS regulations concerning the economic effect test) at the end of each taxable year being equal to the amount of cash that would be distributed to the partner in a hypothetical liquidation of the partnership in which the partnership’s assets are sold for their book values (as determined for purposes of maintaining the partners’ capital accounts). In most cases, allocations pursuant to a target allocation methodology do not satisfy the requirements for economic effect. As a result, partnerships using a target allocation methodology typically take the position that the partnership’s allocations satisfy the PIIP test. The manner in which the CCA determined the PIIP based on the partners’ liquidating distribution entitlements and using the partners’ capital accounts (presumably as computed under the IRS regulations concerning the economic effect test) generally supports the position that the target allocation methodology results in allocations for US federal income tax purposes that satisfy the PIIP test, particularly in circumstances (such as in the CCA) where certain partners are entitled to preferred returns of capital.
- The CCA may foreshadow that partnership allocations will be subject to greater IRS scrutiny in connection with IRS examinations involving partnerships, particularly given that, under new partnership audit rules, which are effective for partnership taxable years beginning after December 31, 2017, and generally apply to all partnerships required to file a US tax return, a partnership may be liable for taxes resulting from reallocations of partnership tax items among its partners.
- The CCA serves as a reminder that US federal tax laws apply in determining the tax items of a non-US partnership, and a US taxpayer’s share of those items, for US federal income tax purposes, regardless of whether the partnership has any US presence. A US taxpayer considering an investment in a non-US partnership should seek to ensure that the partnership will maintain books and records sufficient to allow the US taxpayer to satisfy its US tax compliance obligations.