Selling partnerships that own CFCs: A potential trap for the unwary
INSIGHT ARTICLE |
In addition to many other tax benefits, partnerships offer flowthrough treatment for the partners, which generally results in only one layer of tax and a high level of tax efficiency. In the international tax context, partnership structures are widely used, particularly as collective investment vehicles such as private-equity funds, hedge funds, mutual funds, etc. Businesses such as manufacturers and service providers also commonly use partnerships. As businesses seek to avoid corporate taxes, the use of partnerships (and other flowthrough vehicles) has increased.
Partnerships carry a number of traps for the unwary, as the interaction between the technical partnership rules and myriad 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 treated as a conduit. In addition, 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, and each partner merely owns an interest in the partnership and is not treated as conducting the activities of the partnership.
The authorities underlying whether to apply the aggregate or entity theory to particular areas of partnership taxation are extensive and outside the scope of this item, but the rules governing which approach to take with respect to a particular provision of the Code generally are based on which theory more appropriately achieves that particular Code section's policy goals.
This item highlights a potential trap in the context of a fairly simple fact pattern-the sale of an interest in a partnership (U.S. or foreign) where the partnership owns stock of a controlled foreign corporation (CFC). Specifically, it addresses whether gain recognized on a sale of a partnership that owns CFC stock should 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. An exception to this general rule is contained in section 751.
Section 751(a) generally provides that any amount received by a partner in exchange for all or a part of the partner's interest in the underlying unrealized receivables or 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, by 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. shareholder that owns 10 percent or more of the voting stock of a CFC sells stock in that CFC, section 1248 recharacterizes the gain on such a sale as a dividend, to the extent of the undistributed earnings and profits (E&P) attributable to the stock sold (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.
If the selling U.S. shareholder is a noncorporate taxpayer (e.g., an individual), the deemed dividend may be treated as a qualified dividend eligible for reduced 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. Qualified dividend income is eligible for a reduced rate for noncorporate taxpayers (currently, a maximum rate of 20 percent, the same rate applicable to capital gains). However, since individuals and other noncorporate taxpayers do not receive indirect foreign tax credits under section 902 on dividends from foreign corporations (although they may claim direct foreign tax credits on any taxes paid on foreign dividends), the application of section 1248 is generally tax-neutral in this context (assuming the CFC is in a tax treaty jurisdiction).
However, section 1248 does not apply in all circumstances. Section 1248(g) lists specific exceptions where the application of section 1248 is precluded and gain on the sale of CFC's stock is not recharacterized as a dividend. 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."
Neither Treasury nor the IRS has issued formal guidance on the application of sections 751(c) and 1248(g)(2)(B) to sales of partnership interests, and no court has ruled on the interaction of these provisions. 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 Regs. 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).
Additionally, in T.D. 9644, Treasury stated 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 this language, 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, which 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 nonpreferential 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 because 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. In addition, 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 to treat the CFC as a disregarded entity (a so-called check-and-sell transaction), which would result in a deemed liquidation of the CFC followed by a distribution of the CFC's assets to the partnership for U.S. tax purposes. 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.
Clearly, some of these approaches depend on all partners of the partnership agreeing to the same holding and 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 facilitate an exiting member, particularly 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).
Finally, a taxpayer may be able to take a position contrary to the government's position based on policy grounds. For example, 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 viable position, but it should be fully vetted, and taxpayers should carefully consider whether this position can be taken, consistent with current return preparer standards and the potential need to disclose the position to the IRS.
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.
Excerpted from the April 2015 issue of The Tax Adviser. Copyright © 2015 by the American Institute of Certified Public Accountants, Inc.