Selling partnerships that own CFCs: A potential trap for the unwary
INSIGHT ARTICLE |
Partnerships offer flow-through tax treatment for their partners, meaning income earned by the partnership is taxed as if earned by the partners directly. Flow-through taxation generally results in only one layer of tax and a higher level of tax efficiency as compared to the two-tier system of taxation that applies to businesses operating as corporations. Partnerships are widely used in multinational structures, particularly as collective investment vehicles such as private equity funds, hedge funds and mutual funds. Additionally, businesses such as manufacturers and service providers commonly use partnerships. As businesses seek to avoid the two-tier system of corporate taxation, the use of partnerships (and other flow-through vehicles such as S corporations) has increased.
Despite their many tax advantages, partnerships carry a number of traps for the unwary. The interaction between the technical partnership rules and complex international tax rules is often unclear. Many issues arise because of uncertainty over which theoretical approach to partnership taxation-either the aggregate or entity approach-applies. Under the aggregate theory, a partnership is viewed as an aggregation of its partners and the partnership is merely a conduit. Therefore, the partners are treated as directly engaged in the partnership's activities. Conversely under the entity theory, the partnership is treated as an entity separate from its partners. Each partner merely owns an interest in the partnership and is not treated as conducting the activities of the partnership.
A larger discussion of the theories regarding when to apply aggregate or entity approach is outside the scope of this discussion. However, both entity and aggregate theories are used throughout the Code based largely on which theory more effectively achieves that particular code section's policy goals.
The sale of an interest in a partnership (U.S. or foreign) where the partnership owns stock of a controlled foreign corporation (CFC) is a simple fact pattern that highlights the difference between the aggregate and entity theories. Specifically, should gain recognized on a sale of a partnership that owns CFC stock be treated as capital gain or ordinary income?
Sale of partnership interests‒in general
Under section 741, the sale of a partnership interest is treated as the sale of a capital asset. As such, the partner recognizes a capital gain or loss, depending on the amount realized from the sale and the partner's outside basis in the partnership interest. Thus, section 741 represents an application of the entity theory, with the partner treated as selling an interest in a separate entity.
However, section 751 contains an exception to the entity approach of section 741. Generally, under section 751 any amount received by a partner in exchange for his interest in certain underlying assets (i.e., unrealized receivables and inventory items) of the partnership is considered an amount realized from the sale or exchange of property other than a capital asset. Congress enacted section 751 in 1954 to prevent the conversion of potential ordinary income into capital gain upon the transfer of a partnership interest. The statute accomplishes this by applying an aggregate approach, in which the partner is treated as directly selling the ordinary income-producing property.
Under section 751(c), the term "unrealized receivable" includes stock in a CFC, but only to the extent of the amount that would be treated as gain to which section 1248(a) would apply.
Section 1248‒in general
In general, if a U.S. person owns 10 percent or more of the voting stock of a CFC and sells stock in that CFC, any gain recognized on such a sale is treated as a dividend under section 1248, but only to the extent of any undistributed earnings and profits (E&P) attributable to the stock sold and accumulated during periods when the foreign company is a CFC (the section 1248 amount). If the selling U.S. shareholder is a C corporation, gain treated as a dividend under section 1248 is generally eligible for foreign tax credit relief under section 902. Corporations do not receive preferential tax rates on dividends from foreign corporations or capital gains recognized on the sale of stock. Therefore, the application of section 1248 generally produces a benefit to corporations.
However, if the selling U.S. shareholder is a noncorporate taxpayer (e.g., an individual), the deemed dividend may be treated as a qualified dividend and eligible for reduced tax rates under section 1(h)(11). For a U.S. shareholder to claim a reduced rate, the CFC must be a "qualifying corporation." Specifically, the CFC must be eligible for the benefits of a tax treaty listed in Notice 2011-64. Currently qualified dividends received by an individual shareholder are subject to a maximum rate of 20 percent, the same rate applicable to capital gains. Section 1248, however, does not apply in all circumstances. Section 1248(g) lists specific exceptions where gain on the sale of a CFC's stock is not recharacterized as a dividend. For example, under section 1248(g)(2)(B), section 1248 does not apply to "any amount to the extent that such amount is, under any other provision of this title, treated as . . . ordinary income." However, the application of this provision where a taxpayer sells an interest in a partnership that owns a CFC is unclear.
Neither the Treasury nor the IRS has issued formal guidance on the application of sections 751(c) and 1248(g)(2)(B) to the sale of a partnership interest, and no court has ruled on the interaction of these provisions either. However, language in the preamble to the section 1248 regulations suggests that section 1248 does not apply to sales of partnership interests. In T.D. 9345, Treasury commented that language in Reg. section 1.1248-1(a)(4) relating to the treatment of sales of CFC stock by non-U.S. partnerships was not intended to apply to the sale by a partner of its interest in a non-U.S. partnership holding stock of a CFC because it would be contrary to section 1248(g)(2)(B).
Furthermore, Treasury stated in T.D. 9644 that:
"[t]he Treasury Department and the IRS believe that the section 1411 characterization of the section 751(c) amount that corresponds to a section 1248 dividend should be consistent with the chapter 1 characterization and not treated as a dividend, and thus do not adopt the recommendation to treat the amount as net investment income under section 1411(c)(1)(A)(i) or add an example to the final regulation."
Based on the language of T.D. 9644, it appears the government believes that the sale of an interest in a partnership that owns a CFC should be treated as the sale of a noncapital asset (to the extent of the untaxed E&P as computed under section 1248) and produce ordinary income under section 751(c). This ordinary income inclusion would not be eligible for dividend treatment under section 1248 due to the application of section 1248(g)(2)(B). Qualified dividend rates would therefore not apply. If section 1248 does not apply to a sale of a partnership interest, a corporate seller of an interest in a partnership that owned a CFC could not use section 1248 to characterize the section 751(c) income as a dividend and receive the benefit of indirect foreign tax credits. Noncorporate taxpayers would be taxable at ordinary income rates.
Treasury's position appears to rely on a technical reading of the code. This could be construed as inconsistent with the congressional intent and tax policy underlying section 751 because an indirect sale of a CFC through a partnership produces a worse result than a direct sale. This result appears to be a technical glitch that has resulted from the enactment of preferential rates for dividends subsequent to the enactment of section 751.
If a partner were to sell a CFC interest directly, section 1248 would clearly apply. Gain would be recharacterized as a dividend to the extent of the section 1248 amount and potentially be eligible for a reduced tax rate under section 1(h)(11). Similarly, if a partnership sold the CFC, the section 1248 amount would be recharacterized at the partnership level and flow through to the partners. Under the Treasury approach, the interposition of a partnership would convert income otherwise eligible for preferential dividend treatment into non-preferential ordinary income. The approach would therefore produce results different from what might result under an aggregate approach. This seems contrary to the original intent of section 751, which generally applies an aggregate approach to sales of partnership interests.
If the CFC is in a tax treaty jurisdiction (and is eligible for treaty benefits) or the selling shareholder is a corporate taxpayer, the Treasury position arguably reaches the wrong result. Under the Treasury position, gain on the sale of a partnership that directly owns the CFC would result in ordinary income rather than qualified dividend treatment. If the selling partner is a noncorporate taxpayer and the CFC is located in a nontreaty territory, then the interaction between section 751(c) and section 1248(g)(2)(B) appears to reach the correct result, albeit through different means. In this case, it would turn an amount that would otherwise be eligible for a reduced rate as a capital gain into an amount taxed at ordinary income rates, thus achieving the same result as if the partner had sold it directly.
Arguably, the correct policy approach would be to have section 1248 apply to the section 751(c) amount and to tax this amount under other relevant Code sections (e.g., section 1(h)(11)). This would reflect an aggregate approach consistent with the policy underlying section 751.
Are there alternatives?
Depending on the facts, avenues may exist to ensure section 1248 treatment and avoid an adverse result under the Treasury approach. Obviously a direct sale of the CFC by the partnership would be taxed under section 1248. A synthetic asset sale (e.g., contributing the CFC stock to a disregarded entity and selling the disregarded entity) could also result in dividend treatment under section 1248. This dividend would flow through to the partners and be taxed accordingly, based on each partner's corporate or noncorporate taxpayer status.
Another alternative would be to "check the box" immediately prior to sale so that the CFC is treated as a disregarded entity. This is often referred to as a "check-and-sell transaction." The result for U.S. tax purposes is a deemed liquidation of the CFC followed by a distribution of the CFC's assets to the partnership. While taxpayers typically use this strategy to avoid subpart F income on the sale of CFC stock, the deemed liquidation of the CFC would likely be taxed under section 1248 and not section 751 because gain recognized on a liquidation is generally taxable under section 1248. Any gain subsequently recognized by the selling partner on a sale of the partnership interest would be taxable under section 751, but only to the extent of any unrealized receivables in the asset base of the former CFC.
Another possible approach would be to contribute the stock of the CFC to a U.S. corporation prior to the partner's exiting the partnership. This could avoid the application of section 751 because stock in a U.S. corporation is not subject to section 751.
The difficulty in applying the above-referenced solutions is that all partners of the partnership must agree to the same holding period, exit strategies and timing with regard to the investment in the CFC. If all partners exit the partnership at the same time, these approaches may be viable. However, if the exiting partner is a minority owner, the other partners may be unwilling to modify their investments to benefit an exiting member. This is particularly true if the suggested approach would cause all of the partners to realize income (e.g., if the partnership sells a CFC directly or makes a check-the-box election).
A taxpayer may ultimately decide the best solution is to take a position contrary to the government's view. An individual taxpayer could take the position that section 751 should not apply in lieu of section 1248 because the mechanical operation of sections 751(c) and 1248(g)(2)(B) results in a worse outcome compared with the partner's selling the assets directly; a consequence inconsistent with the general legislative intent underlying section 751. Given the lack of direct guidance to the contrary, this may be a reasonable position. However, taxpayers should carefully consider whether this position can be substantiated and, consistent with current return preparer standards, a position contrary to government guidance may require disclosure.
The uncertainty surrounding the interaction of sections 751(c) and 1248(g)(2)(B), along with Treasury's comments on the matter, should lead taxpayers and their advisers to tread carefully when planning a partner's exit from a partnership. At the very least, a calculation should be performed to identify the potential exposure arising if qualified dividend treatment is not available and determine whether the risk is material. If possible, alternative transaction structures should be considered to mitigate this potential risk, but this may not always be possible.