IRS Issues Final and Proposed Regulations Addressing Partnerships and Section 956 and the Active Rents and Royalties Exception

November 11, 2016

On November 3, 2016, the Internal Revenue Service (the "IRS") and the Treasury Department ("Treasury") issued final regulations (the "Final Regulations") providing rules regarding the treatment under section 956 of "United States property" held by controlled foreign corporations ("CFC") through partnerships and expanding the scope of the section 956 anti-avoidance rule.  Along with the Final Regulations, the IRS and Treasury also issued proposed section 956 regulations (the "Proposed Regulations") addressing certain determinations regarding related parties.  The Final Regulations also contain rules for determining whether a CFC is considered to derive rents and royalties in the active conduct of a trade or business for purposes of determining whether the CFC has earned foreign personal holding company income ("FPHCI"). 

The Final Regulations generally adopt, with some changes, the temporary and proposed regulations that were issued on September 2, 2015 (the "2015 Temporary Regulations" and the "2015 Proposed Regulations," respectively), and also withdraw Revenue Ruling 90-112.  The Final Regulations are effective beginning November 3, 2016.  The Proposed Regulations are proposed to be effective for tax years of CFCs ending on or after the Proposed Regulations are finalized.


I.    Section 956

Under section 956, a U.S. shareholder (as defined in section 951(b)) must include in gross income its pro rata share of a CFC’s investment in U.S. property.  The amount of a CFC’s investment in U.S. property is determined, in part, based on the average of the amounts of U.S. property held, directly or indirectly, by the CFC at the close of each quarter during its taxable year.  Generally, the amount taken into account with respect to any U.S. property is the adjusted basis of the property, reduced by any liability to which the property is subject.[1]  Although existing regulations under section 956 provided that a CFC-partner is treated as holding its proportionate share of a partnership’s U.S. property,[2] before the issuance of the Final Regulations, there was no meaningful guidance regarding how to determine a CFC-partner’s share of the U.S. property held by a partnership.  In addition, although Revenue Ruling 90-112 limited a CFC-partner’s share of a partnership’s U.S. property to the CFC-partner’s adjusted basis in its partnership interest (its "outside basis"), and it was widely accepted by taxpayers and the tax bar that this outside basis limitation had been incorporated into the Treasury regulations, the government had never formally confirmed this point.

Under section 956(c), U.S. property includes an obligation of a U.S. person, and, under section 956(d) and Treas. Reg. § 1.956-2(c), a CFC is treated as holding an obligation of a U.S. person if the CFC is a pledger or guarantor of the obligation.  Therefore, if a CFC makes or guarantees a loan to a U.S. person, an income inclusion may be required with respect to the CFC under sections 951(a)(1)(B) and 956.  Under section 956, U.S. property also includes certain receivables acquired by a CFC from U.S. persons acquired in certain related party factoring transactions.[3]

Before the issuance of the 2015 Temporary Regulations, the anti-avoidance rule provided that a CFC is considered to hold indirectly investments in United States 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) the other foreign corporation was to avoid the application of section 956 with respect to the CFC.  The 2015 Temporary Regulation modified the anti-avoidance rule so that the rule also applies when a foreign corporation controlled by a CFC is funded other than through capital contributions or debt and expanded the rule to apply to transactions involving partnerships that are controlled by a CFC.

II.    Foreign Personal Holding Company Income

The regulations under section 954 provide "developer exceptions" and "active marketing exceptions," whereby rental and royalty income of a CFC are excluded from FPHCI if the income is derived by the CFC from leasing or licensing property in an active trade or business.  The 2015 Temporary Regulations, in an effort to more clearly distinguish between passive investment income and active business income, inserted the words "through its own officers or staff of employees" three times throughout Temp. Treas. Reg. § 1.954-2T. Thus, the developer exceptions, as modified by the 2015 Temporary Regulations, referred to property that the CFC, through its own officers or staff of employees, has manufactured or developed or created or produced, or has acquired and, through its own officers or staff of employees, added substantial value to, but only if the CFC, through its own officers or staff of employees, is regularly engaged in the manufacture or development or creation or production of, or in the acquisition of and addition of substantial value to, property of such kind.

The Final and Proposed Regulations

I.    Partnership Property Held by a CFC Through a Partnership

          A.    Calculation of Partner’s Attributable Share of Partnership Property:  Liquidation Value Percentage

The Final Regulations provide that the amount of U.S. property attributed to a CFC partner from a partnership is determined by reference to the partner’s "liquidation value percentage," or "LVP," i.e. a percentage based on a partner’s rights to cash on the sale by the partnership of all of its assets, the settling of its liabilities, and the distribution of the remaining proceeds to the partners.[4]  The Final Regulations retain the rule from the 2015 Proposed Regulations that the determination of a partner’s LVP takes into account special allocations, as long as the special allocation does not have the principal purpose of avoiding the application section 956.  For purposes of section 956, allocations pursuant to section 704(c) are not special allocations.[5]   

Generally, a partner’s LVP must be re-determined upon a "revaluation" event specified in the section 704(b) regulations.[6]  (Those events include certain contributions, distributions, issuances of compensatory equity, and exercises of partnership options and conversion rights.[7])  In response to comments that partners’ relative economic interests in the partnership may change significantly as a result of allocations of income or other items under the partnership agreement even in the absence of a revaluation event, the Final Regulations provide that a partner’s liquidation value percentage must be re-determined in certain additional circumstances.  Specifically, if the LVP determined for any partner on the first day of the partnership’s taxable year would differ from the most recently determined LVP of that partner by more than 10 percentage points, then the LVP must be re-determined on that day even in the absence of a revaluation event.

The IRS and Treasury also issued Proposed Regulations that would eliminate the ability to take into account special allocations when applying the LVP method with respect to any partner that controls the partnership.  For this purpose, a partner is treated as controlling a partnership if the partner and the partnership are related within the meaning of section 267(b) or section 707(b), substituting "at least 80 percent" for "more than 50 percent."  The Proposed Regulations, if finalized, would mark a dramatic change in the tax law by disregarding the effect of valid special allocations.

          B.    Outside Basis and Revenue Ruling 90-112 

Under the Final Regulations, the amount of a partnership’s U.S. property that is attributed to its partners is based upon the partnership’s basis in the property without regard to the partner’s basis in its partnership interest.[8]  Revenue Ruling 90-112, which limited the amount of U.S. property attributed to the partner to its outside basis, is obsolete as of November 3, 2016.  Accordingly, taxpayers no longer can rely on outside basis to limit the amount of U.S. property held by a CFC indirectly through a partnership, although taxpayers may rely on the outside basis limitation for tax years ending before November 3, 2016.

The IRS and Treasury eliminated the outside basis limitation because they were concerned that a limitation determined by reference to a partner’s outside basis was less consistent with section 956(a), which provides that the amount of U.S. property directly or indirectly held by a CFC is determined by reference to the adjusted basis of the U.S. property itself, and further, that, under the partnership tax rules of subchapter K, adjustments may be made to outside basis through the allocation of liabilities under section 752 that are inconsistent with the policy of section 956.  In our view, though such concerns may be justified, removing the outside basis limitation may place taxpayers in the incongruous position of having inclusions under section 956 when they hold property indirectly through a partnership, where they would not have inclusions if they held the property directly.  It should be noted that incongruities in the tax law, while being traps for the unwary, often lead to planning opportunities.   

          C.    Obligations of Foreign and Domestic Partnerships

                        1.    Generally      

The Final Regulations generally treat the obligations of a foreign partnership as obligations of its partners by reference to the partner’s LVP.[9]  As a result, if a CFC holds an obligation of a foreign partnership, and one or more of the partners is a U.S. person, then the obligation will be treated as an obligation of a U.S. person for purposes of section 956, which could result in a section 956 inclusion by the U.S. shareholder of the CFC.  Under an important exception, however, the partners will not be treated as obligors under a partnership’s obligations if neither the CFC that holds the obligation nor any person related (within the meaning of section 954(d)(3)) to the CFC is a partner in the partnership on the CFC’s quarterly measuring date under section 956.[10]  The Final Regulations also provide that an obligation of a domestic partnership is in all cases treated as an obligation of a U.S. person.[11]

                        2.    Funding Transactions

The Final Regulations include a special "funded distribution" rule that applies to situations in which (1) a CFC makes a loan to a partnership, (2) the partnership makes a distribution to a partner who is related (within the meaning of section 954(d)(3)) to the CFC (a "related CFC"), and (3) the distributee-partner is a person whose obligation would be treated as U.S. property if held by the CFC, and (4) the partnership would not have made the distribution "but for" the funding of the partnership by the CFC.  If all four requirements are satisfied, the distributee-partner’s share of the partnership’s obligation is the greater of (i) its share under the LVP method or (ii) the lesser of (x) the amount of the distribution that would not have been distributed but for the funding and (y) the amount of the obligation.  Under the Final Regulations, the "but for" requirement is deemed to be satisfied to the extent that, immediately before the distribution, the partnership would not have had sufficient liquid assets to make the distribution if it had not incurred the obligation to the related CFC. 

D.    Factoring Transactions

The Final Regulations also finalize the 2015 Proposed Regulations under Treas. Reg. § 1.956-3, as well as proposed regulation issued on June 4, 1988, both of which addressed various factoring transactions.  Specifically, the Final Regulations provide rules for treating indirect acquisitions of trade or service receivables as having been acquired by a CFC.  A CFC is treated as indirectly acquiring the trade or service receivable from a related U.S. person if the CFC participates in a lending transaction that results in (i) a loan to a U.S. person who purchases inventory property or services from a related U.S. person or (ii) the purchases of trade or service receivables from a related U.S. person, if the loan would not have been made or maintained on the same terms but for the corresponding purchase.  The amount of the U.S. property is the lesser of the amount of the loan and the purchase price.  The Final Regulations also treat a CFC as acquiring the trade or service receivable of a related U.S. person when the receivable is acquired from an unrelated person who acquired (directly or indirectly) the receivable from a person who is a related person to the acquiring person. 

E.    Anti-Avoidance Rule

The Final Regulations adopt the substantive rules of the 2015 Temporary Regulations and also include examples and a coordination rule.

Substantive RulesConsistent with the 2015 Temporary Regulations, the anti-avoidance rule under the Final Regulations applies if the CFC funds a partnership that is controlled by the CFC.  For this purpose, a CFC is treated as controlling a foreign corporation or partnership if the CFC and the foreign corporation or partnership are related within the meaning of section 267(b) or section 707(b).  The Final Regulations also provide that in cases in which the funding was done for purposes of avoiding section 956, the term funding includes funding "by any means" – i.e. funding through a means other than capital contributions or debt.

Examples of Funding Transactions.  In response to comments on the 2015 Temporary Regulations, the Final Regulations include examples that illustrate the distinction between funding transactions that are subject to the anti-avoidance rule and common business transactions to which the anti-avoidance rule does not apply.

Coordination Rule.  Comments to the 2015 Proposed Regulations noted that a CFC could be treated as holding duplicative amounts of U.S. property as a result of a single partnership obligation under the general rule and the anti-avoidance rule.  As a result, the Final Regulations expand the coordination rule proposed in the 2015 Proposed Regulations to prevent a CFC from being treated as holding duplicative amounts of U.S. property under the anti-avoidance rule as a result of a partnership obligation.

II.    Foreign Personal Holding Company Income

The Final Regulations finalize definitions from the 2015 Temporary Regulations for determining whether rents and royalties are considered derived in the active conduct of a trade or business, in which case they are excluded from FPHCI.

   [1]   Treas. Reg. § 1.956-1(e)(1).

   [2]   Treas. Reg. § 1.956-1(b).

   [3]   I.R.C. § 956(c)(3).

   [4]   Treas. Reg. § 1.956-4(b).

   [5]   Treas. Reg. § 1.956-4(b)(2)(ii).  The Final Regulations are silent on whether other required allocations, such as the "qualified income offset" under Treas. Reg. § 1.704-1(b)(2)(ii)(d) and the various allocations with respect to nonrecourse deductions required under Treas. Reg. § 1.704-2, constitute special allocations.

   [6]   Treas. Reg. § 1.956-4(b)(2)(i)(B)(2).

   [7]   Treas. Reg. §§ 1.704-1(b)(2)(iv)(f)(5), -1(b)(2)(iv)(s).

   [8]   Treas. Reg. § 1.956-4(b)(1).

   [9]   Treas. Reg. § 1.956-4(c)(1).

[10]   Treas. Reg. § 1.956-4(c)(2).

[11]   Treas. Reg. § 1.956-4(e).

The following Gibson Dunn lawyers assisted in the preparation of this client alert:  Eric Sloan, Jeff Trinklein and Nina Xue.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments.  For further information, please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the Tax Practice Group:

Art Pasternak - Co-Chair, Washington, D.C. (+1 202-955-8582, [email protected])
Jeffrey M. Trinklein - Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
David B. Rosenauer - New York (+1 212-351-3853, [email protected])
Eric B. Sloan – New York (+1 212-351-2340, [email protected])
Romina Weiss - New York (+1 212-351-3929, [email protected])
Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, [email protected])
Hatef Behnia – Los Angeles (+1 213-229-7534, [email protected])
Paul S. Issler – Los Angeles (+1 213-229-7763, [email protected])
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Scott Knutson – Orange County (+1 949-451-3961, [email protected])
David Sinak – Dallas (+1 214-698-3107, [email protected])   


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