When Is a Domestic Partnership a Foreign Partnership? Schro¨dinger's Cat Redux

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By Kenneth J. Krupsky, Esq.

Jones Day, Washington, DC 

In Notice 2010-41, 2010-22 I.R.B. 715, the Treasury and the IRS announced their intention to issue regulations to treat certain domestic partnerships as foreign partnerships, solely for purposes of identifying the U.S. shareholders of a controlled foreign corporation (CFC) that are taxable on Subpart F income (and §956 amounts). Notice 2009-7, 2009-3 I.R.B. 312, previously identified the particular targeted transaction, described below, and substantially similar transactions, as a "transactions of interest" that must be disclosed under Regs. §1.6011-4.

The regulations will apply to taxable years of an otherwise domestic partnership ending on or after May 14, 2010.  No inference is intended as to the treatment of a domestic partnership for any prior year, and the IRS may challenge positions taken by taxpayers for such transactions, including under Subpart F and Subchapter K, or under judicial doctrines such as the sham transaction, substance-over-form, and economic substance doctrines.

The transaction in Notice 2010-41 is described as follows: A U.S. person ("Taxpayer") wholly owns CFC1 and CFC2, each of which owns 50% of CFC3 through a domestic partnership.  CFC3 has Subpart F amounts under §951. Taxpayer takes the position that it does not have a Subpart F or §956 income inclusion with respect to CFC3, because the domestic partnership (not Taxpayer) is the first U.S. person in the chain of ownership of CFC3. The government believes that Taxpayer's position is contrary to the purpose and intent of §951.

Section 7701(a)(4) provides that the term "domestic" when applied to a corporation or partnership means an entity created or organized in the United States unless, in the case of a partnership, the Secretary provides otherwise by regulations. Section 7701(a) provides that any general definition therein does not apply where such definition is "manifestly incompatible" with the intent of the relevant Code provision. The cited "unless" clause of §7701(a)(4) was added to the Code in the Taxpayer Relief Act of 1997. The Senate Committee Report states, "It is expected that a recharacterization of a partnership as foreign rather than domestic under such regulations will be based only on material factors such as the residence of the partners and the extent to which the partnership is engaged in business in the United States or earns U.S.-source income." And the Conference Committee report says a reclassification is expected "only in unusual cases."

Note also that, absent the new regulations, the domestic partnership is the U.S. shareholder of the CFC that is required to include the relevant amounts in gross income, and those amounts would then generally flow up to the partners (CFC1 and CFC2) in accordance with the partnership agreement. The government states, however, that the domestic partnership's gross income inclusion may have "little or no tax consequences," depending on the treatment of each partner's distributive share of such income.

This Notice is excellently analyzed by Kim Blanchard elsewhere in this publication, with reference to Schro¨dinger's famous "cat." She focuses on the potential for taxpayers to slice the government with its own sword, and descries the "IRS's unambiguous intention to write a `heads I win, tails you lose' rule." I'm shocked! Yours truly (a former government employee) hopes the Treasury and the IRS will take this analysis to heart in drafting the regulations.

Yet I see the central issues to be addressed in a slightly different light (both waves and particles, or neither?).  Specifically, the regulations to be issued will treat an otherwise domestic partnership as a foreign partnership, solely for this purpose, if the following conditions are satisfied:1. The partnership is a U.S. shareholder of a CFC; and

2. If the partnership were treated as foreign:

a. The foreign corporation would continue to be a CFC; and

b. At least one U.S. shareholder of the CFC:

i. Would be treated under §958(a) as indirectly owning stock of the CFC owned by the partnership that is indirectly owned by a foreign corporation; and

ii. Would be required to include an amount in gross income under §951(a) with respect to the CFC. 

What are we to make of this apparently "mechanical" rule, as sketched in the Notice? I would suggest that the regulations should not be stiffly mechanical, but rather supple enough to curtail true abuses – i.e., particular factual cases that are "unusual" and are "manifestly incompatible" with the intent of the relevant Code provisions. If a particular intermediate "Schro¨dinger's box" U.S. partnership serves no business purpose other than to "absorb" Subpart F income, and then to distribute such income to its partners under the terms of the partnership and the partnership tax rules, then, yes, it makes sense to me that the tax result should disregard – or recast, if you like – this very limited single tax impact of the partnership. The structure itself, with nothing more, arguably creates a likelihood of improper tax avoidance. If it is likely, then says the government, let us conclude it is so – not presume, conclude.

But there could be all sorts of legitimate business purposes for the structure at issue. For example, there might at some point in the past have been unrelated foreign owners of the domestic partnership, who formed the structure for a valid business purpose and left the structure for a different valid business purpose – wholly unrelated to U.S. taxes. One of the prior owners might have been a U.S. tax-exempt entity. One or both of CFC1 and CFC2 in the structure might at one point in the past not have qualified as a CFC, but became so as a result of an independent business transaction. 

One would hope that the regulations will take into account such possibly relevant facts, and no doubt others that others can think of, rather than applying a purely mechanical rule to all cases with a superficial resemblance. Should not the regulatory rule be a rebuttable presumption, rather than a conclusive recast?

This commentary also will appear in the July 2010 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Yoder, 926 T.M., Subpart F—General, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.