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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Schrödinger designed a physics thought experiment to explain why, in quantum mechanics theory, sometimes subatomic particles appear to behave as waves and other times as particles. The thought experiment involved a cat in a box containing a sort of Rube Goldberg contraption. In the thought experiment, Schrödinger proved that the poor cat was both alive and dead simultaneously (and probably quite confused). Apparently, the IRS believes that partnerships are subject to the laws of quantum mechanics, and can act simultaneously as aggregates and as entities. This seems, at least, to be the confusing theory – novel in the tax world – underpinning Notice 2010-41.1
Recall that in Notice 2009-7,2 the IRS announced that the so-called domestic partnership blocker structure was a "transaction of interest." That structure involves a U.S. person, let's say domestic corporation DC, that owns a CFC (CFC3) through a domestic partnership owned by two or more other CFCs (the "partner CFCs") owned by the same U.S. person. If CFC3 earns Subpart F income, such income will be Subpart F income at the partnership level, and will pass through the partnership to the partner CFCs. However, because the partner CFCs are foreign persons, they do not have Subpart F inclusions.
This odd result occurs because the IRS applies the definition of "U.S. shareholder" in §951 literally, so as to include a domestic partnership, even though a partnership is not a taxpayer. That is, the IRS insists that a partnership is an entity for purposes of Subpart F. If instead the domestic partnership had been foreign, and thus, as an entity, not a U.S. shareholder, the §958 attribution rules would have looked through it and any upper-tier foreign entities (the partner CFCs) until they found a U.S. person, here, DC. Notice 2009-7 offered no real authority for its questioning of the result of the blocker structure; it merely observed that the result was "contrary to the purposes and intent of" Subpart F. Notice 2010-41 observes similarly, but more forcefully, that the result is "manifestly incompatible with" the intent of Subpart F, yet admits that the result is consistent with the technical operation of the statute. Unlike the earlier Notice, however, Notice 2010-41 does offer authority for its position. That authority is in §7701(a)(4), which defines as "domestic" a partnership organized under U.S. law, unless "the Secretary provides otherwise by regulations."3
Notice 2010-41 announced that the IRS will issue regulations that will classify a domestic partnership as a foreign partnership solely for the purpose of identifying those U.S. shareholders required to include CFC3's Subpart F income in income under §951(a). The new Notice does not do this in the obvious, straightforward or principled manner of simply exercising its authority under §7701(a)(4) to treat a domestic partnership as foreign for all purposes of §951. Nor does the Notice adopt a simple, sensible aggregate rule across the board. Instead, the Notice attempts to classify a domestic partnership as foreign only in the fact pattern addressed in Notice 2009-7. It does this as explained below.
Section 4.01 of the Notice first treats the domestic partnership as an entity and as domestic in order to make the partnership a "U.S. shareholder" of CFC3. It then reclassifies the domestic partnership as foreign only in the case in which, if the partnership were foreign, CFC3 would still be a CFC, and at least one U.S. shareholder of CFC3 would be treated as indirectly owning CFC3 stock by reason of §958 and would be required to include an amount in income in respect of CFC3's Subpart F income. This approach was quite clearly intended to preserve current law as applied to a foreign corporation that is a CFC solely by reason of being owned by a domestic partnership, but that would not be a CFC if instead the partnership were foreign. The IRS's unambiguous intention was to write a "heads I win, tails you lose" rule.4
The danger of any ad hoc rule not based on principle is that it will tend to backfire when applied to facts not envisioned by its drafter. There are clearly cases in which Notice 2010-41 will actually benefit taxpayers and hurt the fisc. In fact, these cases are more likely to be encountered in practice than the cases at which the Notice was aimed, such that the net effect of the Notice is a revenue loser.
For example, most practitioners have long taken the view – although not completely clear under the statute and regulations – that if a foreign corporation is owned by a domestic partnership such that it is a CFC, all U.S. partners, no matter how small their interests, must report Subpart F inclusions under §951. Notice 2010-41 is clearly to the contrary in that class of cases to which it applies. Consider the following two examples: In the first, the Notice does not apply and all U.S. partners are inclusion shareholders. In the second, the Notice does apply and any U.S. partners who own less than 10% of the underlying CFC are not subject to Subpart F.
Example 1.A foreign corporation is owned by a domestic partnership, but all of its partners are unrelated to one another and none of its partners owns, directly, indirectly, or constructively, as much as 10% of the interests in the partnership, however determined. Notice 2010-41 does not apply, because the CFC would not be a CFC if the partnership were classified as foreign. Accordingly, the foreign corporation is a CFC under the general rule. Most practitioners believe that all U.S. partners would have Subpart F inclusions.
Example 2.A foreign corporation is owned by a domestic partnership. CFC partners owned by a single U.S. corporation own 51% of the partnership interests. The other 49% is owned 7% each by seven U.S. individuals unrelated to each other, or to the CFCs or to their U.S. shareholder. Notice 2010-41 applies, because the foreign corporation would be a CFC even if the partnership were foreign, and the U.S. shareholder of the CFC partners would be an inclusion shareholder. However, because the Notice classifies the partnership as foreign, none of the individual 7% partners is a U.S. shareholder and there is no theory for requiring any of them to take any Subpart F income into account.
Under Notice 2009-7, it was not clear that a taxpayer could rely on the treatment that the IRS suggested here. Under this new Notice, however, it seems clear that once a partnership is reclassified, even if "solely" for purposes of determining who is a Subpart F inclusion person, the rule can be relied upon in Example 2 above. Thus, the Notice should bring relief to those U.S. taxpayers finding themselves in that structure.
Some taxpayers may attempt to affirmatively "plan into" the Notice. One can imagine a market in CFCs (who would act as the controlling partners) owned by U.S. persons who are indifferent to Subpart F inclusions. Those persons might be invited into partnerships and given interests that, while "controlling" for purposes of §957 or §953, represent minimal economics. Although the IRS might attack such structures under the economic substance doctrine or on other grounds, it seems unlikely that such attacks would prevail, given that the partners could have formed a foreign partnership to get to the same end result. All such planning really nets the parties is the ability to use a domestic partnership rather than have to set up a foreign one.
The foregoing highlights a particular problem not addressed by the Notice. Under the approach of the Notice, it will be critical to know how to attribute "voting" stock of a foreign corporation up through a domestic partnership to its partners to find a 10% U.S. shareholder by vote, within the meaning of §951(b). This issue has long existed with respect to foreign partnerships that, because they are not U.S. persons, are looked through under the attribution rules of §958. The regulations under §958 provide no guidance as to how voting power is attributed to the partners.
Some practitioners believe that because §951(b) employs a voting test, only the general partner's ownership interest should be counted in determining whether there is an indirect 10% U.S. shareholder. Other practitioners take the view that attribution should be based on economics, treating limited partners as owning their shares based on their economic percentage interests. These practitioners also point out that although in form a general partner controls the voting of the foreign corporation's shares, it does so only as a fiduciary on behalf of the limited partners. Even if one believes that economic sharing should determine the percentage of voting stock owned indirectly, it can be difficult to determine what economic percentages to use, because a partner may have different percentages of capital and profits, and different percentages at different points in the "waterfall." Given these uncertainties, many practitioners test both ways, finding a Subpart F issue if either the general partner or the limited partners could be treated as owning a sufficient interest in the foreign corporation.
Notice 2010-41 extends these measurement uncertainties to domestic partnerships. In many cases, taxpayers will be unable to determine whether the Notice applies absent guidance as to how attribution applies through partnerships.
Notice 2010-41 is predicated upon the theory that the domestic partnership blocker structure is "manifestly incompatible" with the purpose and intent of Subpart F. Perhaps what is manifestly incompatible with the purpose and intent of Subpart F is in the eye of the beholder, but one might as well say that it would be "manifestly incompatible" with the purpose and intent of Subpart F to require small (less than 10%) U.S. shareholders of a foreign corporation to bear Subpart F inclusions simply because they happen to own a foreign corporation through a domestic, rather than through a foreign, partnership. A better solution to the domestic partnership blocker structure, that would serve to shut down this particular planning while serving simultaneously to comport with the evident purpose and intent of Subpart F, would be for the IRS to treat all partnerships as aggregates. If §7701(a)(4) is authority to achieve the result of Notice 2010-41, it is authority to achieve a broadly more rational result for all taxpayers, not just those that the IRS does not like.
Result-oriented rules that have no principle to recommend themselves invite trouble for the government in two ways. First, they can produce unintended, taxpayer-favorable results. Second, they encourage those who view the tax rules as a game, rather than as a set of principles based on the rule of law, to continue to play the game. And when the tax law becomes a game, taxpayers will always win. Notice 2010-41 is an example, perhaps one of the worst so far, of the IRS behaving as a tax shelter promoter, reading rules literally and contentlessly to achieve a desired result. The IRS would do well to post on its website Marty Ginsburg's law: "Every stick crafted to beat on the head of a taxpayer will, sooner or later, metamorphose into a large green snake and bite the Commissioner on the hind part."5
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 Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, and Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties — U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively Connected Income, and ¶7160, U.S. Income Tax Treaties.
3 Whether §7701(a)(4) in fact confers the authority to issue Notice 2010-41, particularly to the extent it applies retroactivley, is open to question. See Cummings, "The Subpart F Blocker and Manifest Incompatibility," 106 Daily Tax Rpt. J-1 (6/4/10).
4 As drafted, the Notice applies where all of the partnership's partners are U.S. persons. In such a case, treating the partnership as foreign could have serious effects on PTI and basis. It seems likely that the IRS did not intend this result, but it is unclear what taxpayers should or may do until this glitch, if it is one, is fixed.
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