07 November 2016 IRS and Treasury issue final subpart F regulations The Treasury Department (Treasury) and the Internal Revenue Service (IRS) have issued final regulations (T.D. 9792) (the final regulations) addressing the application of the Section 956 anti-abuse rule as a result of a funding by a foreign corporation and the application of Section 956 in connection with certain transactions with partnerships. The final regulations also provide guidance on the application of the "active rents and royalties" exception to the foreign personal holding company income (FPHCI) rules under Section 954, and rules for determining whether a CFC holds US property as a result of certain related-party factoring transactions under Section 956. The final regulations replace the temporary (TD 9733) and proposed (REG-155164-09) regulations under Sections 954 and 956 released in September 2015 (the 2015 Regulations). (For discussion of the 2015 Regulations, see Tax Alert 2015-1760.) Concurrently with the issuance of final regulations, Treasury and the IRS also published proposed regulations requiring a CFC that is a partner in a controlled partnership to use the liquidation valuation percentage method to determine its share of US property held by the partnership. The IRS and Treasury in REG 122387-16 also withdrew portions of earlier proposed regulations addressing stock redemptions through related corporations, the application of Section 956 to US property indirectly held by a CFC, related-party factoring transactions and the definition of "obligation" for Section 956 purposes. — Addition of examples to Reg. Section 1.956-1(b) anti-avoidance rule to 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 — Expansion of the coordination rule in proposed Reg. Section 1.956-1(b)(4)(iii) to prevent a CFC from being treated as holding duplicative amounts of United States (US) property under the anti-avoidance rule — Withdrawal, as obsolete, of Revenue Ruling 90-112 regarding the measurement of US property by the CFC's adjusted basis in the partnership — Expansion of the circumstances in which the partner's liquidation value percentage must be re-determined to cover circumstances other than a revaluation event — Revision of the general rule in Reg. Section 1.956-4(c) to implement the liquidation value percentage method (to parallel the rules in final Reg. Section 1.956-4(b)) — Revision of the definition of special allocations in Reg. Section 1.956-4(b)(2)(ii) to clarify that a special allocation is an allocation of book income or gain, rather than a tax allocation such as the allocations required under Section 704(c) and clarification of the meaning of special allocation for purposes of the final regulations — Clarification of the "but for" requirement in Reg. Section 1.956-4(c)(3) regarding foreign partnership distributions funded by a CFC The final regulations modifying the active development test under Section 954 apply to rents or royalties received or accrued during tax years of CFCs ending on or after September 1, 2015, and to tax years of US shareholders in which or with which such tax years end, but only for property manufactured, produced, developed, or created, or, in the case of acquired property, property to which substantial value has been added, on or after September 1, 2015. Similarly, the final regulations modifying the active marketing test under Section 954, as well as the rules regarding cost-sharing arrangements, apply to rents or royalties, as applicable, received or accrued during tax years of CFCs ending on or after September 1, 2015, and to tax years of US shareholders in which or with which such tax years end, to the extent that those rents or royalties are received or accrued on or after September 1, 2015. The Section 956 anti-avoidance rules in Reg. Section1.956-1(b) apply to tax years of CFCs ending on or after September 1, 2015, and to tax years of US shareholders in which or with which such tax years end, for property acquired, including property treated as acquired as the result of a deemed exchange of property under Section 1001, on or after September 1, 2015. The rules regarding factoring transactions in Reg. Section 1.956-3 apply to trade or service receivables acquired (directly or indirectly) after March 1, 1984. The remaining rules in the final regulations generally apply to tax years of CFCs ending on or after November 3, 2016, and tax years of US shareholders in which or with which those tax years end. In general, these remaining rules apply to property acquired, or pledges or guarantees entered, on or after September 1, 2015, including property considered acquired, and pledges and guarantees considered entered, on or after September 1, 2015, as a result of a deemed exchange under Section 1001. However, rules dealing with obligations of disregarded entities and domestic partnerships apply to all obligations held on or after November 3, 2016. Finally, rules dealing with partnership property indirectly held by a CFC apply to property acquired on or after November 3, 2016. The final regulations amend headings for two sections of the regulations (Reg. Sections 1.956-1 and 1.956-1T) as well as the rules in Reg. Section 1.956-1(a) to reflect the statutory changes made under the Revenue Reconciliation Act of 1993 (1993 Act) regarding the method for calculating the amount determined under Section 956 with respect to a US shareholder of a CFC. The preamble to the final regulations notes that the Treasury and IRS were aware that some taxpayers had attempted to apply parts of the prior regulations, which did not reflect revisions made by the 1993 Act, to tax years covered by the 1993 provision and these revisions have been made to avoid confusion. The 2015 Regulations modified the anti-avoidance rule of Treas. Reg. Section 1.956-1T(b)(4) so that it could apply when a foreign corporation controlled by a CFC is funded other than through debt or capital contributions and expanded the rule to apply to transactions involving partnerships that are controlled by a CFC. While rejecting comments requesting the narrowing of the funding provision, the IRS and Treasury added new examples (Examples 4, 5, and 6 of Reg. Section 1.956-1(b)(4)) 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. Prop. Reg. Section 1.956-1(b)(4)(iii) contained a coordination rule regarding the application of the anti-abuse rule and the partnership rules. With respect to this rule, a comment received pointed out that "a CFC also could be treated as holding duplicative amounts" of US property by applying Prop. Reg. Sections 1.956-1(b)(4), the anti-avoidance rule and 1.956-4(c), the partnership rule. Consider, for example, a domestic corporation (P) that wholly owns two CFCs (FS1 and FS2). P is also a 40% partner in a foreign partnership (FPRS), and FS1 is the 60% partner. FS2 would be treated as holding $40x of US property under Prop. Reg. Section 1.956-4(c) and could be treated as holding $100x of US property acquired by the partnership under Prop. Reg. Section 1.956-1(b)(4) and Reg. Section 1.956-2(a). Because Treasury and the IRS believe the amount of US property that FS2 is treated as holding should be limited to $100x, "consistent with the result that would apply if FS2 had not funded FPRS's acquisition of [US] property and had instead acquired the [US] property itself," the final regulations expand the coordination rule to prevent the CFC from being treated as holding duplicative amounts of US property under the anti-avoidance rule. The 1988 Prop. Reg. Section 1.956-3 addressed the application of Section 956 to property acquired by a CFC in certain related-party factoring transactions. The 2015 regulations proposed revisions to these rules in Prop. Reg. Section 1.956-3(b)(2)(ii) with respect to the application of Section 956 to acquisitions of receivables indirectly through a nominee, pass-through entity, or related foreign corporation. Given that no comments were received on these proposed rules, the final regulations adopt these portions of the 2015 proposed regulations without change, and also adopt the remainder of the rules in Prop. Reg. Section 1.956-3 that were proposed in the 1988 proposed regulations, with minor revisions to improve clarity and conform to existing regulations. The final regulations in Reg. Section 1.956-4(b)(1) treat a CFC partner in a partnership as holding its attributable share of the partnership's property, and provide that the partner's adjusted basis in the partnership's property equals the partner's attributable share of the partnership's adjustable basis in the property. The CFC partner's attributable share of partnership property is determined, under Reg. Section 1.956-4(b)(2), in accordance with the partner's liquidation value percentage with respect to the partnership. If, however, a partnership agreement provides for the allocation of book income or book gain from a subset of the property of the partnership to a partner other than a partner's liquidation value percentage, then the partner's attributable share of property is determined by reference to that special allocation, provided the special allocation does not have a principle purpose of avoiding the purposes of Section 956. The preamble to the final regulations notes that Revenue Ruling 90-112 (addressing how US property held by a CFC indirectly through a partnership is treated under Section 956) provided an outside basis limitation (limited by the CFC's adjusted basis in the partnership). Although the revenue ruling was generally consistent with Reg. Section 1.956-2(a)(3), because the CFC that is a partner in a partnership is treated as indirectly holding property held by the partnership when the property would be US property if the CFC held it directly, the ruling also limits the amount of US property that may be taken into account to the CFC's adjusted basis in the partnership property — a limitation "that is not included in the final or proposed regulations." As a result, the final regulations withdraw Revenue Ruling 90-112 as obsolete. Under proposed Reg. Section 1.956-4(c), a partner's share of partnership obligations was determined in accordance with the partner's interest in partnership profits. In response to comments received, the final regulations change this rule and provide that the same method — the liquidation value percentage — should be used for determining both a partner's share of partnership obligations under Treas. Reg. Section 1.956-4(c) and a partner's share of partnership property under Treas. Reg. Section 1.956-4(b). Treasury and the IRS acknowledge that the application of a single method reduces complexity for taxpayers that would otherwise need to apply two sets of rules for purposes of Section 956 to a single partnership. Under Prop. Reg. Section 1.956-4((b)(2)(i), a liquidation value percentage must be redetermined when a "revaluation event" occurs. One comment noted that "partners' relative economic interest in the partnership may change significantly as a result of allocation of income or other items under the partnership agreement even in the absence of a revaluation event." In response, the final regulations expand the rule in Reg. Section 1.956-4((b)(2)(B) to require a partner's liquidation value percentage to be redetermined in certain additional circumstances (e.g., if the liquidation value percentage determined for a partner on the first day of the partnership's tax year would differ by more than 10 percentage points from the most recently determined liquidation value percentage for that partner). The final regulations revise the definition of special allocations in Reg. Section 1.956-4(b)(2)(ii) to clarify that a special allocation is an allocation of book income or gain, rather than a tax allocation such as the allocations required under Section 704(c). In addition, the final regulations also clarify that, for purposes of the final regulations, a special allocation means only an allocation of income (or, when appropriate, gain) from a subset of the property of the partnership to a partner other than in accordance with the partner's liquidation value percentage in a particular tax year. The final regulations reject the comments recommending that the final regulations abandon an aggregate approach under which a CFC loan to a foreign partnership is generally treated as a separate loan of the partners and retain the aggregate approach of the proposed regulations. Thus, under final Reg. Section 1.956-4(c), an obligation of a foreign partnership should be treated as an obligation of its partners in proportion to the partners' liquidation value percentage (for this purpose, special allocations are not taken into account) , unless the exception in Reg. Section 1.956-4(c)(2) (for obligations of partnerships in which neither the lending CFC nor any person related to the lending CFC is a partner) or the special rule in proposed Reg. Section 1.956-4(c)(3) (regarding certain partnership distributions) applies. The 2015 Regulations had provided a special funded distribution rule under which the amount of a foreign partnership obligation treated as US property is increased if all of the following conditions are met: 1. A CFC lends, pledges or guarantees funds to a foreign partnership with an obligation that is US property with respect to the CFC under Prop. Reg. Section 1.956-4(c)(1) and Reg. Section 1.956-2(a). 2. The partnership distributes money or property to a partner related to the CFC and has an obligation that would be US property if held, or treated as held, by the CFC. 3. The foreign partnership would not have made the distribution but for a funding of the partnership through an obligation held, or treated as held, by the CFC. 4. The distribution exceeds the partner's share of the partnership obligation as determined in accordance with the partner's interest in the partnership's profits. In response to comments regarding the "but for" requirement suggesting that "taxpayers might take the position that a partnership distribution could have been made without the funding by the CFC merely by establishing that a third party would have loaned the funds needed for the partnership to make the distribution," the IRS and Treasury provide the following clarification: a foreign partnership will be treated as if it would not have made a distribution of liquid assets but for a funding of the partnership through obligations held (or treated as held) by a CFC to the extent the foreign partnership did not have sufficient liquid assets to make the distribution immediately prior to the distribution, without taking into account the obligations. In REG-114734-16, Treasury and the IRS propose rules regarding how to determine the amount of US property treated as held by a CFC through a partnership. According to the preamble, Treasury and the IRS are concerned that special allocations with respect to a partnership that is controlled by a single multinational group are unlikely to have economic significance for the group as a whole and can facilitate tax planning inconsistent with the purposes of Section 956. Specifically, the regulations propose to amend Reg. Section 1.956-4(b) so that a CFC that is a partner in a controlled partnership determines its share of US property held by the partnership under the liquidation value percentage method, regardless of the existence of any special allocation of income or gain from the property. A partner would be treated as controlling a partnership if the partner and partnership were related within the meaning of Section 267(b) and Section 707(b) substituting at least 80% for more than 50%. The final regulations largely adopt the 2015 Regulations, thereby expanding the anti-avoidance rule in Section 956 and adopting a broad aggregate approach in addressing CFC loans to foreign partnerships. As a result, the final regulations significantly increase the instances in which a CFC may be treated as holding US property (especially an obligation of a US person), thus increasing the likelihood of an income inclusion to the US shareholders of the CFC under Section 951(a)(1)(B). Although comments were received requesting guidance, the final regulations do not address situations in which multiple CFCs serve, or are treated, as pledgor or guarantors of single obligation for purposes of Section 956(d). Thus, in the absence of guidance in this area, the application of the final regulations will likely cause multiple inclusions to occur. Nevertheless the regulations introduce some positive changes and clarifications to the 2015 regulations. First, while the funding rule remains unchanged, the final regulations add new examples to 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. Second, the final regulations provide that a single method — the liquidation value percentage — should be used for determining a partner's share of partnership property and a partner's share of partnership obligations. The use of a single method will reduce complexity for taxpayers that will no longer have to apply two set of rules (the liquidation value percentage and the partner's interest in partnership profits) with respect to a single partnership. Third, the expansion of the circumstances in which the partner's liquidation value percentage must be re-determined covers when the partners' relative economic interests in the partnership change for reasons unrelated to re-valuation events. Fourth, the expansion of the coordination rule in Proposed Reg. Section 1.956-1(b)(4)(iii) prevents a CFC from being treated as holding duplicative amounts of US property under the anti-avoidance rule. Finally, taxpayers should be aware that the regulations are generally retroactive to some extent as outlined previously.
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