|
The IRS and the
Treasury Department received a number of comments in response to
these proposed regulations expressing concern about the proposed
treatment of section 704(c) layers in connection with a partnership
merger. In addition, the IRS and the Treasury Department have
become aware that practitioners are taking positions based upon
different interpretations of the current tiered partnership rules
(Treas. Reg. §1.704-3(a)(9)). A number of practitioners suggest
that the tiered partnerships rules may need to be clarified and
similar rules be provided with respect to partnership mergers. The
IRS and Treasury believe that further study of certain aspects of
the application of section 704(c) is necessary before finalizing the
Proposed Merger Regulations.
Section 704(c), in relevant part,
provides:
(c)
CONTRIBUTED PROPERTY.—
(1)
IN GENERAL.—Under
regulations prescribed by the Secretary—
(A) income, gain, loss,
and deduction with respect to property contributed to the
partnership by a partner shall be shared among the partners so as to
take account of the variation between the basis of the property to
the partnership and its fair market value at the time of
contribution,
(B) if any property so contributed is
distributed (directly or indirectly) by the partnership (other than
to the contributing partner) within 7 years of being contributed –
(i) the contributing partner shall be
treated as recognizing gain or loss (as the case may be) from the
sale of such property in an amount equal to the gain or loss which
would have been allocated to such partner under subparagraph (A) by
reason of the variation described in subparagraph (A) if the
property had been sold at its fair market value at the time of
distribution.
Section 704(c)(1)(A) was enacted as
part of the Tax Reform Act of 1984 (P.L. 98-369). Congress
determined that “special rules are needed to prevent an artificial
shifting of tax consequences between the partners with respect to
pre-contribution gain or loss. This is particularly important since
the various partners may have different tax positions.” H.R. Rep.
No. 432, Pt. 2, 98th
Cong., 2d Sess., 1209 March 5, 1984. See also, Staff of
Joint Committee on Taxation, 98th
Cong., 2d Sess., General Explanation of H.R. 4170, 212, Dec. 31,
1984.
Section 704(c)(1)(B) was enacted as
part of the Omnibus Budget Reconciliation Act of 1989 (P.L.
101-239). It was Congress’s view that the prior law made it
“possible for partners to circumvent the rule requiring
pre-contribution gain on contributed property to be allocated to the
contributing partner.” S. Finance Comm. 101st
Cong., Revenue Reconciliation Act of 1989, Explanation of Provisions
Approved by the Committee on Oct. 3, 1989, 196 (Comm. Print 1989).
While section 704(c)(1)(B) addresses
the recognition of gain by the contributing partner if property
contributed by the partner is distributed to another partner,
section 737 addresses the tax consequences when a partner who
contributed built-in gain or loss property receives a distribution
of other property.
Sections 737(a) and (b), in relevant
part, provide:
(a) GENERAL
RULE. In the case of
any distribution by a partnership to a partner, such partner shall
be treated as recognizing gain in an amount equal to the lesser of—
(1) the excess (if any) of
(A) the fair market value of property
(other than money) received in the distribution over
(B) the adjusted basis of such
partner’s interest in the partnership immediately before the
distribution reduced (but not below zero) by the amount of money
received in the distribution, or
(2) the net precontribution gain of
the partner.
Gain recognized
under the preceding sentence shall be in addition to any gain
recognized under section 731. The character of such gain shall be
determined by reference to the proportionate character of the net
precontribution gain.
(b) NET
PRECONTRIBUTION GAIN. For purposes of this section, the term “net precontribution
gain” means the net gain (if any) which would have been recognized
by the distributee partner under section 704(c)(1)(B) if all
property which—
(1) had been
contributed to the partnership by the distributee partner within 7
years of the distribution, and
(2) is held by
such partnership immediately before the distribution, had been
distributed by such partnership to another partner.
Sections 737(a)
and (b) were enacted as part of the Energy Policy Act of 1992 (P.L.
102-486) as a result of Congress’s concern that “a partner who
contributes appreciated property to a partnership may be able to
avoid or defer the recognition of gain with respect to that property
through the mechanism of having the partnership distribute other
partnership property to him in partial or complete redemption of his
interest while the partnership continues to own the contributed
property.” H.R. Rep. 102-631, 102nd
Cong., 2d. Sess., 68 (June 30, 1992). See also, S.
Finance Comm. Technical Explanation, 138 Cong. Record S11246,
S11265, Aug. 3, 1992 (Daily Ed.). Final regulations under sections
704(c)(1)(B) and 737 were issued in T.D. 8642, dated December 22,
1995. Amendments to these provisions were included in T.D. 8717,
dated May 8, 1997, T.D. 9193, dated March 21, 2005 and T.D. 9207,
dated May 23, 2005.
On August 22, 2007, the IRS and the
Treasury Department published in the Federal Register
(2007-41 I.R.B. 790 [72 FR 46932]) a notice of proposed rulemaking
(REG-143397-05) (the Proposed Merger Regulations), consistent with
Notice 2005-15 (2005-1 C.B. 527), providing that (1) section
704(c)(1)(B) applies to newly created section 704(c) gain or loss in
property contributed by the transferor partnership to the continuing
partnership in an assets-over merger, but does not apply to newly
created reverse section 704(c) gain or loss resulting from a
revaluation of property in the continuing partnership, and (2) for
purposes of section 737(b), net precontribution gain includes newly
created section 704(c) gain or loss in property contributed by the
transferor partnership to the continuing partnership in an
assets-over merger, but does not include newly created reverse
section 704(c) gain or loss resulting from a revaluation of property
in the continuing partnership. On November 6, 2007, corrections to
the proposed regulations were published in the Federal Register
(72 FR 62608).
The proposed regulations include
several examples. Example (3) of the proposed regulations
(see Treas. Proposed Reg. §1.704-4(c)(4)(ii)(F), Example (3))
involves a situation where built-in gain property contributed to the
transferor partnership has both a revaluation loss in the transferor
partnership and additional gain upon merger with the transferee
partnership. The example concludes that the section 704(c) layers
are collapsed in the merger and that upon contribution to the
transferee partnership the property had only built-in gain and no
built-in loss.
Example 3 is as follows.
Example (3).
Revaluation loss and merger gain. (i) Facts. On January 1, 2005, A
contributes Asset 1, with a basis of $200x and a fair market value
of $300x, to partnership PRS1 in exchange for a 50 percent
interest. On the same date, B contributes $300x of cash to PRS1 in
exchange for a 50 percent interest. Also on January 1, 2005, C
contributes Asset 2, with a basis of $100x and a fair market value
of $200x, to partnership PRS2 in exchange for a 50 percent
interest. On the same date, D contributes $200x of cash to PRS2 in
exchange for a 50 percent interest. PRS1 and PRS2 both have
provisions in their respective partnership agreements requiring the
revaluation of partnership property upon entry of a new partner.
PRS2 would not be treated as an investment company (within the
meaning of section 351) if it were incorporated. Neither
partnership holds any unrealized receivables or inventory for
purposes of section 751. In addition, neither partnership has a
section 754 election in place. Asset 1 and Asset 2 are
nondepreciable capital assets.
Later on in 2005,
PRS2 admitted E as a new partner in PRS2 at a time when the fair
market value of Asset 2 was $150x and PRS2’s only other asset was
cash of $200x. In exchange for a contribution of cash of $175x, E
was admitted as a one-third partner in PRS2. In accordance with the
terms of PRS2’s partnership agreement, the partnership revalued its
assets upon admission of E so that the unrealized loss of $50x
attributable to Asset 2 was allocated equally between C and D, or
$25x each. On January 1, 2008, PRS 2 merges into PRS1. At the time
of the merger, PRS1’s only assets are Asset 1, with a fair market
value of $900x, and $300x in cash. PRS2’s only assets are Asset 2,
with a fair market value of $600x, and $375x in cash. After the
merger, the partners have book capital and profits and loss
interests in PRS1 as follows: A, 27.5%; B, 27.5%; C, 15%; D, 15%;
and E, 15%. On January 1, 2013, Asset 2 is distributed to A when
its value is still $600.
(ii) Analysis.
On the date of the merger of PRS2 into PRS1, the fair market value
of Asset 2 ($600x) exceeded its adjusted tax basis ($100x). Thus,
when Asset 2 was contributed to PRS1 in the merger, it was section
704(c) gain property. The total amount of the section 704(c) gain
was $500x ($600x (fair market value) – 100x (adjusted basis)). The
amount of the original section 704(c) gain attributable to Asset 2
equals $50x, the difference between its fair market value ($200x)
and adjusted tax basis ($100x) upon contribution to PRS2 by C, less
the unrealized loss ($50x) attributable to the revaluation of PRS2
on the admission of E as a partner in PRS2. The amount of the new
section 704(c) gain attributable to Asset 2 equals $450x, the total
section 704(c) gain ($500x) less the amount of the original section
704(c) gain ($50x). The distribution of Asset 2 to A occurs more
than seven years after the contribution by C to PRS2. Therefore,
pursuant to §1.704-4(c)(4)(ii)(A), section 704(c)(1)(B) does not
apply to the original section 704(c) gain. The distribution of
Asset 2 to A, however, occurs within seven years of the contribution
of Asset 2 to PRS1 and PRS2. Pursuant to §1.704-4(c)(4)(ii)(B),
section 704(c)(1)(B) applies to the new section 704(c) gain. As the
transferees of PRS2’s partnership interest in PRS1, C, D and E each
succeed to $150 of new section 704(c) gain. Thus, as a result of
the distribution of Asset 2 to A within seven years of the merger,
C, D and E are each required to recognize $150 of gain.
A number of rules in existing
regulations may be relevant to mergers, divisions and tiered
partnerships. In particular Treas. Reg. §1.704-3(a)(7)-(9) may
apply.
Treas. Reg. §1.704-3(a)(7) provides
rules when a partner transfers his partnership interest and provides
a “step in the shoes” approach:
(7) Transfer of a partnership
interest.—If a contributing partner transfers a partnership
interest, built-in gain or loss must be allocated to the transferee
partner as it would have been allocated to the transferor partner.
If the contributing partner transfers a portion of the partnership
interest, the share of built-in gain or loss proportionate to the
interest transferred must be allocated to the transferee partner.
This rule does not apply to any person who acquired a partnership
interest from a §1.752-7 liability partner in a transaction in which
paragraph (e)(1) of §1.752-7 applies. See §1.752-7(c)(1).
Treas. Reg. §1.704-3(a)(8) provides
special rules for certain specific situations, including the
disposition of section 704(c) property in a nonrecognition
transaction. Treas. Reg. §1.704-3(a)(8)(i) states, in relevant
part:
(8) Special rules.—(i)
Disposition in a nonrecognition transaction.—If a partnership
disposes of section 704(c) property in a nonrecognition transaction,
the substituted basis property (within the meaning of section
7701(a)(42)) is treated as section 704(c) property with the same
amount of built-in gain or loss as the section 704(c) property
disposed of by the partnership. If gain or loss is recognized in
such a transaction, appropriate adjustments must be made. The
allocation method for the substituted basis property must be
consistent with the allocation method chosen for the original
property.
Guidance on allocations with regard
to the contribution of section 704(c) property in a tiered
partnership structure is provided in Treas. Reg. §1.704-3(a)(9):
(9) Tiered partnerships.—If a
partnership contributes section 704(c) property to a second
partnership (the lower-tier partnership), or if a partner that has
contributed section 704(c) property to a partnership contributes
that partnership interest to a second partnership (the upper-tier
partnership), the upper-tier partnership must allocate its
distributive share of lower-tier partnership items with respect to
that section 704(c) property in a manner that takes into account the
contributing partner’s remaining built-in gain or loss. Allocations
made under this paragraph will be considered to be made in a manner
that meets the requirements of §1.704-1(b)(2)(iv)(q)
(relating to capital account adjustments where guidance is lacking).
Section 3.
DISCUSSION
While no requests for a hearing were
received in response to the proposed regulations issued on August
22, 2007, the IRS and the Treasury Department did receive comments
relating to the proposed regulations and took notice of a number of
articles published in response to the proposed regulations.
Most of the comments and articles
address Example (3) which provides that property either has a
built-in gain or built-in loss upon merger, not both, and that
original section 704(c) gain is reduced by subsequent revaluation
losses. Several comments discussed not only the specifics of
Example (3), but also the broader implications of the example.
In particular, the commentators questioned whether the example
implies that a subsequent revaluation loss would reduce prior
section 704(c) gains rather than create a new section 704(c) loss
layer where there has been no partnership merger. Another comment
suggested that the section 704(c) allocations in the example could
be different if, for example, the transferor partnership used the
remedial method instead of the traditional method. Other
commentators expressed concerns that the application of the proposed
regulations would result in tax allocations after the merger that
are not consistent with the economic arrangement of the partners of
the transferor partnership. For example, if layers of reverse
section 704(c) built-in gain or built-in loss are collapsed in the
merger, then a partner who prior to the merger was allocated a net
loss for book purposes with respect to the property would not
recognize a corresponding tax loss until liquidation of its
interest. They contend that if the transferor partnership had
continued in existence instead of liquidating, the section 704(c)
layers would have been preserved under the tiered partnership rules
of Treas. Reg. §1.704-3(a)(9). Some practitioners believe the
results should be the same in a merger.
The IRS and the Treasury Department
have also become aware that there are conflicting views among
practitioners about how section 704(c) layers should be maintained
with respect to tiered partnerships. One view is that an aggregate
approach should apply or be permitted such that a tiered partnership
arrangement can be “looked through” and section 704(c) applied as if
the partners of the upper-tier partnership directly own a portion of
the assets of the lower-tier partnership (the Aggregate Approach).
Another view is the entity approach under which the upper-tier
partnership is treated as owning an interest in the lower-tier
partnership but is not treated as owning any interest in the section
704(c) property of the lower-tier partnership (the Entity
Approach). Each approach raises different issues and has unique
consequences.
After extensive consideration of the
concerns raised, the IRS and the Treasury Department believe that
comments would be helpful to the development of guidance concerning
section 704(c) layers in tiered partnerships and in mergers and
divisions. The IRS and Treasury Department believe that it is
appropriate to consider the issues regarding section 704(c) layers
in general before finalizing the Proposed Merger Regulations.
Section 4.
REQUEST FOR COMMENTS
The IRS and
Treasury Department are seeking comments relating to section 704(c)
layers, as well as other section 704(c) issues, with respect to
tiered partnerships, mergers and divisions. The IRS and the
Treasury Department plan to address these issues as part of a future
guidance project. However, the IRS and Treasury Department are not
requesting comments on the principles described in Notice 2005-15,
2005-1 C.B. 527.
The IRS and Treasury Department
include examples below of the types of comments requested, but
comments are requested on all aspect of these issues, not only those
matters listed.
Single
Partnership with Layers – No Tiers
1. Should any
changes be made to the events in Treas. Reg. § 1.704-1(b)(2)(iv)(f),
the occurrence of which allow for a revaluation of assets? Should
additional events be added?
2. After
revaluing property, when, if at all, is it appropriate for taxpayers
to net additional differences between value and basis against
existing section 704(c) layers and when is it appropriate to create
new section 704(c) layers if the layers offset one another (e.g.,
loss and gain layers)?
3. If a
partnership has multiple section 704(c) layers, how should tax
depreciation, depletion, amortization and gain or loss be allocated
between the layers? When is it appropriate for partnerships to
allocate these items to the latest layers first, to earlier layers
first or to allocate these items pro rata to all layers for this
purpose? Are other methods appropriate? How are these amounts
allocated between layers if there are offsetting layers (e.g., how
should depreciation be allocated between layers if a property has
both a $100 gain layer and a subsequent $100 loss layer)?
4. What other
section 704(c) issues are raised relating to section 704(c) layers,
e.g., when partnership property is revalued?
Tiers of
Partnerships with Layers
5. Are changes
necessary to Treas. Reg. § 1.704-3(a)(7) and (8) to address
compliance with section 704(c) and maintenance of section 704(c)
layers when property is either contributed to a partnership or
transferred to a partner in a tiered partnership structure?
6. Are there different
considerations in making property revaluation decisions in tiered
partnership structures than in a single partnership (e.g.,
should a revaluation of an upper-tier partnership constitute a
revaluation event at the lower-tier partnership and should
revaluation be dependent upon whether the upper-tier partnership has
a significant interest in the lower-tier partnership)? Does the
order in which tiered partnerships make property revaluations affect
resulting section 704(c) layers and does existing guidance permit
taxpayers to make revaluations in the appropriate order as
necessary?
7. What issues
relating to section 704(c) must taxpayers address in tiered
partnership structures? What additional issues should be addressed
by the regulations, including Treas. Reg. §1.704-3(a)(9)?
8. When should
Treas. Reg. §1.704-3(a)(9) permit taxpayers to use an Aggregate
Approach or Entity Approach? What should be the results under these
approaches? Should taxpayers be able to use other methods to track
section 704(c) layers?
9. Under the
Aggregate Approach, how would the section 704(c) layers be
maintained by the lower-tier partnership?
10. Is the
information necessary to maintain section 704(c) layers under the
Aggregate Approach readily available? If the Aggregate Approach is
permitted what, if any, additional rules would be necessary so that
the partnerships may secure the required information?
11. Under the Entity Approach, if
after allocating the upper-tier partnership’s distributive share of
lower-tier partnership section 704(c) allocations on the sale of an
asset at the lower-tier level there are remaining book tax
differences in the upper tier partnership, how, if at all, should
these differences be resolved at the upper tier level?
Mergers
12. Recognizing
that the transferor partnership terminates in a merger, what
different issues do mergers raise for the section 704(c) layer rules
?
13. Whether the
Aggregate or Entity Approach is used in tiered partnerships, how
will the approach be affected by a merger of one of the partnerships
in a tiered arrangement, including a partnership that directly holds
section 704(c) property and a partnership with an indirect interest
in the property?
14. Under the
Aggregate Approach, how would the transferee partnership maintain
the section 704(c) layers of the transferor partnership?
15. Under the
Entity Approach, when should the transferee partnership maintain the
layers of the transferor partnership, or should each asset have a
single section 704(c) layer as a result of the merger?
16. Are there
different considerations if the transferor has partnerships as
partners or if the transferee partnership is a partner in another
partnership?
Divisions
17. What issues
regarding section 704(c) layers are raised in a division of a
“traditional” single tier partnership and in the division of a
partnership that is part of a tiered partnership structure?
18. Assuming a partnership division
should not create new section 704(c) property (or section 737 net
precontribution gain) when each partner’s overall interest in each
partnership property does not change, how should section 704(c)
layers be created and maintained when a division is not pro rata
or other changes in partners or property interests occur at the time
of the division?
International
Issues
19. What
international tax issues are raised on the application of section
704(c) layers to tiered partnerships, mergers and divisions? For
example, how should section 704(c) layers be created and maintained
in cross-border tiered partnerships and mergers and divisions?
Should similar “layers” be created and maintained to track and
preserve the character of the gain under international tax
provisions, including sections 367, 897, and 1248?
Comments may be submitted on or
before February 22, 2010 to Internal Revenue Service, PO Box
7604, Washington, DC 20044, Attn: CC:PA:LPD:PR (Notice 2009-70),
Room 5203. Submissions may also be hand-delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to the Courier’s Desk
at 1111 Constitution Avenue, NW, Washington DC 20224, Attn:
CC:PA:LPD:PR (Notice 2009-70), Room 5203. Submissions may also be
sent electronically via the internet to the following email
address:
Notice.comments@irscounsel.treas.gov.
Include the notice number (Notice 2009-70) in the subject line.
Section 5.
DRAFTING INFORMATION
The principal author of this notice
is Laura Fields of the Office of Associate Chief Counsel (Passthroughs
& Special Industries). For further information regarding this
notice, contact Ms. Fields at (202) 622-3050 (not a toll-free call).
|
