27 August 2018 IRS issues guidance on TCJA changes to unrelated business taxable income requirements In Notice 2018-67 (the Notice), the IRS has issued interim guidance, described planned regulations and solicited comments on new Section 512(a)(6), added by the Tax Cuts and Jobs Act of 2017 (TCJA), which requires tax-exempt organizations with one or more unrelated trades or businesses to compute unrelated business taxable income (UBTI) separately for each trade or business. The Notice also includes guidance on the treatment of global intangible low-taxed income for purposes of the unrelated business income tax (UBIT). This guidance is relevant for tax-exempt organizations and also for private equity and other alternative asset management funds (e.g., hedge funds, real estate, energy funds and related fund-of-funds) (collectively "Funds") that have tax-exempt investors. The TCJA enacted numerous tax changes for tax-exempt organizations, individuals and businesses — including new Sections 512(a)(6) and 951A. For a detailed discussion of the TCJA provisions affecting tax-exempt organizations (including Section 512(a)(6)), see Tax Alert 2017-2142. When an organization that is tax-exempt under Section 501(a) derives income from a trade or business that is not substantially related to its exempt purposes, the income is generally subject to UBIT under Section 511. Before enactment of the TCJA, Treasury regulations allowed, in determining UBTI, an organization operating multiple unrelated trades or businesses to aggregate income from all those activities and subtract expenses directly associated with the production of that income. As a result, an organization could use a loss from one unrelated trade or business to offset income from another, thereby reducing total UBTI. New Section 512(a)(6), effective for tax years beginning after December 31, 2017, requires organizations operating more than one unrelated trade or business to compute UBTI separately for each trade or business (without regard to the $1,000 specific deduction under Section 512(b)(12)). The organization's UBTI for a tax year is the sum of the amounts (not less than zero) computed for each separate trade or business (less the Section 512(b)(12) specific deduction). An organization may claim a net operating loss (NOL) deduction only for the trade or business from which the loss arose. Under a special transition rule, net operating losses arising in a tax year beginning before January 1, 2018, and carried forward to a tax year beginning on or after that date are not subject to the new provision. The TCJA also added new Section 951A, which requires a US shareholder of any controlled foreign corporation (CFC) to include in gross income for a tax year its "global intangible low-taxed income" (GILTI) in a manner similar to current subpart F income inclusions. A US shareholder's GILTI for any tax year is the excess, if any, of the US shareholder's "net CFC tested income" over its "net deemed tangible income return." In this manner, GILTI represents an amount deemed in excess of a specified return. For further discussion of GILTI and the TCJA's international provisions, see Tax Alert 2017-2166. As described in further detail later, the Notice contains guidance for purposes of Section 512(a)(6) on multiple issues: 4. Interim and transition rules for aggregating income from partnerships and debt-financed income from partnerships The Notice also provides guidance, described later, on how a GILTI inclusion is treated for purposes of calculating UBTI. The Notice includes guidelines regarding reliance on its rules — in general, stating that exempt organizations may rely on a number of the specific rules and methods that it describes for tax years beginning after December 31, 2017, until proposed regulations are published. Furthermore, the Notice requests comments on the application of Section 512(a)(6) to exempt organizations with more than one unrelated trade or business, and specifically on a number of particular issues identified throughout the Notice. The Notice states that the IRS intends to issue proposed regulations on determining whether an exempt organization has more than one unrelated trade or business for purposes of Section 512(a)(6) and how to identify separate trades or businesses for purposes of calculating UBTI. Until those regulations are issued, the Notice specifies that organizations may rely on a reasonable, good-faith interpretation of Sections 511 through 514, considering all the facts and circumstances, when determining whether an exempt organization has more than one unrelated trade or business for purposes of Section 512(a)(6). For this purpose, the Notice states that a reasonable, good-faith interpretation includes using the North American Industry Classification System 6-digit codes. In addition, the Notice notes that the "fragmentation principle" in Section 513(c) and Reg. Section 1.513-1(b), and related guidance, may also provide helpful guidance. The Notice requests comments on rules for identifying separate trades or businesses under Section 512(a)(6). The IRS would prefer a method that is less burdensome administratively than a facts-and-circumstances test. Therefore, the Notice specifically asks about the usefulness of other Code sections that define a trade or business. Reg. Section 1.512(a)-1(c) and (d) provides special rules for allocating expenses that are shared between an exempt activity and an unrelated trade or business. The Notice states that the IRS is considering modifying the underlying reasonable allocation method in Reg. Section 1.512(a)-1(c) to provide specific standards for allocating expenses relating to dual-use facilities and the rules under Section 512(a)(6). It requests comments on possible rules and what allocation methods should be considered "reasonable." Section 512(b)(4), (13) and (17) treat unrelated debt-financed income, specified payments received from controlled entities, and certain insurance income as items of gross income derived from an unrelated trade or business includable in the calculation of UBTI. The Notice states that the IRS recognizes that one interpretation of Section 512(a)(6) might impose a significant burden on organizations required to include amounts in UBTI under Section 512(b)(4), (13) or (17). This interpretation, for instance, could require treating each debt-financed property owned by an exempt organization as a separate trade or business, or require reporting income from each controlled entity as income from a separate trade or business. Such separate reporting would impose a significant burden on both the organization and the IRS. Accordingly, the Notice states that aggregating income included in UBTI under Section 512(b)(4), (13) or (17) may be appropriate in certain circumstances. The Notice requests comments regarding the treatment under Section 512(a)(6) of income that is not from a partnership, but is included in UBTI under Sections 512(b)(4), (13) and (17). The Notice explains that one interpretation of Section 512(a)(6) might require an exempt organization to calculate UBTI separately for each unrelated trade or business regularly carried on by a partnership in which the exempt organization is a direct or indirect partner. The Notice also notes that the IRS has received comments that this interpretation could result in significant reporting and administrative burdens for exempt organizations with various investment activities, including ownership interests in Funds, which often involves multi-tier partnership structures that generate UBTI or have UBTI flowing through them. As a matter of administrative convenience for both exempt organizations and the IRS, the Notice states that the IRS plans to propose regulations treating certain investment activities of an exempt organization as one trade or business for purposes of Section 512(a)(6)(A) to permit exempt organizations to aggregate gross income and directly connected deductions from such investment activities. This should also alleviate the administrative burden on Funds that need to provide relevant UBTI information to their tax-exempt investors along with Schedule K-1 disclosures. It requests comments regarding the scope of the activities that should be included in this "investment activities" category for purposes of Section 512(a)(6). For this purpose, the Notice specifies that "investment activities" should capture only partnership interests in which an exempt organization does not significantly participate in any partnership trade or business. There are important distinctions and structuring considerations between passive interests in Funds (i.e., investment funds that are not engaged in a trade or business) and flow-through portfolio companies (e.g., private-equity-backed energy and real estate portfolio companies) that are engaged in an active trade or business. The Notice states that, until proposed regulations are issued, and subject to certain exceptions (described next), exempt organizations with partnership interests should use a reasonable, good-faith interpretation of Sections 511 and 514, considering all the facts and circumstances, when identifying separate trades or businesses for purposes of Section 512(a)(6)(A). The exceptions include the following "interim rule" and "transition rule": Interim rule for aggregation of qualifying partnership interests under the de minimis and control tests Under the interim rule, until proposed regulations are issued, an exempt organization may aggregate its UBTI from its interest in a single partnership with multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships, as long as the directly-held interest in the partnership meets the requirements of either the "de minimis test" or the "control test" (qualifying partnership interest). In addition, an exempt organization may aggregate all qualifying partnership interests and treat the group as a single trade or business for purposes of Section 512(a)(6)A). Assuming one of these tests is met, this should benefit tax-exempt investors that are invested in Funds. This is especially true for those Funds that are investor funds but may have interests in underlying portfolio companies, which are tax partnerships, and are engaged in a trade or business (e.g., private-equity-backed flow-through portfolio companies). These tests are fact-specific and will require an analysis of a Fund's investor composition and ownership to be undertaken. Special attention should also be paid to co-investment situations in which tax-exempt investors are invested in a Fund but also have an additional co-investment in a flow-through portfolio company in which the Fund owns an interest. In general, a partnership interest meets the requirements of the de minimis test if the exempt organization holds directly no more than 2% of the profits interest and no more than 2% of the capital interest of the partnership. An organization will be considered to have no more than a 2% profits or capital interest if the average of the organization's percentage interests at the beginning and end of the partnership's tax year, or the organization's percentage interests at the beginning and end of the period of ownership, that are entered in Part II, Line J of Schedule K-1 is no more than 2%. To the extent the profits and/or capital interest is/are not identified on the face of the partnership-issued Schedule K-1, an organization cannot meet the de minimis test. It should be noted that, when determining an exempt organization's percentage partnership interest, the interests of a disqualified person, a supporting organization or a controlled entity in the same partnership have to be aggregated. A partnership interest is a qualifying partnership interest that meets the requirements of the control test if the exempt organization: (1) directly holds no more than 20% of the capital interest in the partnership; and (2) does not have control or influence over the partnership. Control or influence includes: (i) requiring the partnership to perform, or prevent from performing, any act significantly affecting the operations of the partnership; (ii) any of the tax-exempt organization's officers, directors, trustees or employees having rights to participate in the partnership's management activities, and (iii) the tax-exempt organization having the power to appoint or remove any of the partnership's officers, directors, trustees or employees. The same aggregation rule that applies to computing the 2% profits or capital interest for purposes of the de minimis test applies for determining whether the organization holds no more than 20% of the capital interest for purposes of the control test. Pending publication of proposed regulations, an exempt organization may follow the "transition rule" for partnership interests for which it is not applying the interim rule. The Notice states that, because a previously acquired partnership interest may be difficult to modify to meet the de minimis test or control test under the interim rule, an organization may choose to apply the transition rule, if applicable, for a partnership interest acquired before August 21, 2018. Under the transition rule, an exempt organization may treat each such partnership interest as comprising a single trade or business for purposes of Section 512(a)(6) whether or not there is more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnerships. Partnership interests that are treated as separate trades or businesses under the transition rule cannot be further aggregated into a single trade or business. The income from qualifying partnership interests permitted to be aggregated under the interim rule includes any unrelated debt-financed income arising in connection with the qualifying partnership interest that meets either the de minimis rule or the control rule. Therefore, the exempt organization may combine any unrelated debt-financed income with any UBTI otherwise generated by that same qualifying partnership interest and treat the total as one separate trade or business. Similarly, any unrelated debt-financed income that arises in connection with a partnership interest that meets the transition rule may also be aggregated with any other UBTI generated by that partnership interest and thus treated as one separate trade or business. This should streamline the related tax reporting and compliance functions for tax-exempt organizations that are invested in Funds. Section 512(a)(3) provides special rules applicable to exempt organizations described in Section 501(c)(7) (social clubs), 501(c)(9) (voluntary employees' beneficiary associations (VEBAs)) and 501(c)(17) (supplemental unemployment compensation benefits trusts (SUBs)). The Notice states that the IRS expects that any rules issued regarding how an exempt organization identifies separate trades or businesses for purposes of Section 512(a)(6)(A) will apply equally under Sections 512(a)(1) and (3). Nonetheless, because social clubs, VEBAs and SUBs are taxed differently than other exempt organizations under Section 511, the Notice requests comments regarding any additional considerations that should be taken into account within the context of Section 512(a)(3). For fringe benefits, the Notice specifies that the IRS does not believe that the provision of the fringe benefits described in Section 512(a)(7) is an unrelated trade or business. Accordingly, it states that any amount included in UBTI under Section 512(a)(7) is not subject to Section 512(a)(6). Before the TCJA, Section 172 allowed a deduction for net operating losses (NOLs) equal to the sum of NOLs permitted to be carried back to the tax year from succeeding tax years and the NOLs permitted to be carried forward from preceding tax years. The TCJA changed Section 172 by limiting losses incurred in years beginning after December 31, 2017, to the lesser of: (1) the aggregate NOL carryovers to such year, and (2) 80% of taxable income for that year. Furthermore, Section 512(a)(6) changes how an exempt organization with more than one unrelated trade or business calculates and takes NOLs into account for a particular trade or business. The Notice states that Section 512(a)(6) may have changed the order in which an organization would take NOLs because Section 512(a)(6)(A) requires organizations to calculate UBTI separately before calculating total UBTI under Section 512(a)(6)(B). As such, Section 512(a)(6) could be viewed as an ordering rule requiring post-2017 NOLs to be taken before pre-2018 NOLs. The Notice states that the IRS intends to issue guidance regarding how Section 172 generally applies. Because Section 512(a)(6) provides a more specific rule than the one in Section 172 regarding how the NOL deduction is calculated and taken in the context of calculating UBTI, however, the Notice requests comments on how the NOL deduction should be taken under Section 512(a)(6) by exempt organizations with more than one unrelated trade or business (and, in particular, by such organizations with both pre-2018 and post-2017 NOLs). In addition, the Notice requests comments on the ordering of pre-2018 and post-2017 NOLs. The Notice notes that the IRS has received comments asking whether exempt organizations must include GILTI (included in gross income under Section 951A) in the calculation of UBTI and, in particular, whether GILTI is treated in the same manner as an inclusion of subpart F income under Section 951(a)(1)(A) for purposes of UBIT under Section 511. The Notice explains that, because the IRS treats an inclusion of subpart F income as a dividend for purposes of Section 512(b)(1), subpart F income generally is excluded from the calculation of UBTI. The Notice adds that GILTI is not an inclusion of subpart F income under Section 951(a)(1)(A), but instead is a separate inclusion under Section 951A(a). Nonetheless, it notes that an inclusion of GILTI is generally treated in a manner similar to an inclusion of subpart F income for other purposes of the Code. The Notice states that the IRS has determined that an inclusion of GILTI under Section 951A(a) should be treated in the same manner as an inclusion of subpart F income under Section 951(a)(1)(A) for purposes of Section 512(b)(1) and (4). Accordingly, an inclusion of GILTI will be treated as a dividend, which is generally excluded from UBTI under Section 512(b)(1). Therefore, US Funds that have GILTI inclusions will not give rise to UBTI for the Fund's tax-exempt investors. The Notice also addressed questions raised regarding whether Section 512(b)(17) will apply to GILTI that is included in gross income to the extent that it is attributable to insurance income. Under the Notice, the IRS will not treat GILTI included in gross income under Section 951A(a) that is attributable to insurance income as includible in the UBTI of a tax-exempt organization. The information provided in Notice 2018-67 is welcome news to those within the exempt-organization community that have been awaiting guidance from the IRS on those provisions in the TCJA that directly impact exempt organizations. In addition, the Notice is a reminder that significant work still needs to be done to fully implement these provisions via regulations. The IRS and Treasury would like to promulgate a more administrable method than a facts-and-circumstances test (as advocated by some commenters) for identifying separate trades or businesses, for purposes of Section 512(a)(6). For instance, the Notice suggests the use of the North American Industry Classification System and the fragmentation rules under Reg. Section 1.513-1(b) as guides for determining an exempt organization's separate trades or businesses. Before the issuance of final regulations, however, exempt organizations may rely on any reasonable, good-faith interpretation in interpreting Section 512(a)(6), including, but not limited to, the use of NAICS codes and the fragmentation rule, taking into account all facts and circumstances. This guidance acknowledges that that some flexibility exists when determining whether an organization's activities unrelated to its tax-exempt purpose constitute separate trades or businesses and whether and how to aggregate similar unrelated activities as a single trade or business. As requested by many commenters, and to lessen the administrative burden of Section 512(a)(6), the Notice indicates that the IRS and Treasury intend to propose regulations treating investment activities as a single trade or business, for purposes of Section 512(a)(6), thereby permitting exempt organizations to aggregate all gross income and deductions from such activities. The Notice also provides interim and transition rules for aggregating unrelated business income and debt-financed income that derive from partnership investments. Until the proposed regulations are published, organizations should evaluate any partnership investments to determine whether all investment activities are eligible for aggregation under the de minimis test, the control test or the transition rule. These rules should also mitigate the reporting and compliance requirement burden on Funds (including private equity, hedge, real estate, energy funds and fund-of-funds) with tax-exempt investors that meet the interim and transition rules. Exempt organizations may generally rely on these temporary rules until proposed regulations are released. Another favorable aspect of the Notice is its statement that an exempt organization's provision of any qualified fringe benefit to its employees, income from which is taxable under new Section 512(a)(7), is not an unrelated trade or business, and therefore any amounts included in UBTI under Section 512(a)(7) are not subject to the UBTI calculation rules under Section 512(a)(6). This may enable exempt organizations to offset UBTI from Section 512(a)(7) with NOLs from other unrelated trades or businesses. Along with continued good faith compliance with Section 512(a)(6), organizations with NOLs should continue to separately track pre-2018 and post-2017 NOLs to align with activities generated by each separate trade or business, as determined under the Section 512(a)(6) rules. As for the newly enacted Section 951A, exempt organizations will be able to exclude any "global intangible low-taxed income" from the calculation of unrelated business taxable income, even if such income is related to insurance activities. This is another favorable interpretation for which many commenters have advocated. Finally, throughout the Notice, the IRS requests interested parties to provide comments and guidance regarding the implementation of Section 512(a)(6). Exempt organizations and Funds with tax-exempt investors are encouraged to take advantage of the offer to submit comments to the IRS regarding the application of this provision — this is their opportunity to have their individual and collective voices heard regarding the practical application of these TCJA provisions to their organizations. Comments may be submitted to the IRS on or before December 3, 2018.
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