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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
This commentary will prove that something is wrong with the manner in which §751(c), to the extent it picks up income described in §1248(a), operates. But as will be shown, there are any number of culprits to point to as the cause of the problem. Is the problem inherent in §751(c) itself? Does the problem lie in the manner in which the IRS has interpreted that section? Is the problem traceable to the fiction in Rev. Rul. 99-6?1 Or is the answer "all of the above"? Maybe the Tax Management International Journal will allow its readers to vote on this important policy question.
Let us begin with the language and purpose of §751. Section 751 is an acknowledgment that when a partner sells his or her partnership interest, §741 invariably treats the sale as the sale of a capital asset. The result would always be that the selling partner would have capital gain or loss. But §751 alters that result where the assets of the partnership consist of what we might think of as "ripe" ordinary income assets, usually referred to as "hot assets." Where §751 applies, a portion of the selling partner's gain is transmuted from capital to ordinary.
Section 751(c) contains a list of hot assets. It is not terribly surprising to see included in that list "stock in certain foreign corporations (as described in section 1248) … but only to the extent of the amount which would be treated as gain to which section … 1248(a) … would apply if (at the time of the transaction described in this section…) such property had been sold by the partnership at its fair market value." If the subject partnership had sold stock of a controlled foreign corporation (CFC) at a gain, under §1248(a) the portion of that gain equal to the unrepatriated earnings and profits (E&P) of the CFC would be taken into account as a dividend.2 Section 751(c) constructs a deemed sale of the CFC stock by the partnership in order to determine the portion of the selling partner's gain that is treated as a §1248(a)-equivalent and thus as ordinary income.3
The language of §751(c) and the regulations thereunder is clear that the amount of ordinary income is calculated as if the partnership actually sold the CFC stock. The §1248 regulations govern what happens when a partnership sells stock of a CFC. If the partnership is domestic, §1248 applies to it as a separate entity. A U.S. partner of the selling U.S. partnership would then take into account his or her distributive share of the partnership's §1248 dividend. If the selling partnership is foreign, the §1248 regulations provide that a U.S. partner is deemed to sell his or her proportionate share of the CFC stock sold by the foreign partnership.4 That same regulation goes on to state that the U.S. partner is treated as having actually sold that CFC stock "for purposes of applying such sentence," but there is no "such sentence" to be seen.
If either the partnership or the partner had actually sold CFC stock, the amount treated as a dividend by reason of §1248(a) would also free up any foreign taxes paid by the CFC on the subject E&P, which foreign taxes could qualify for the indirect foreign tax credit in the hands of a corporate shareholder.5 This is true whether the
partnership is U.S. or foreign. One might therefore imagine that when §751 applies to tax a selling partner at ordinary income rates on a deemed §1248 dividend, the ordinary income brings with it associated foreign taxes, just as an actual §1248 dividend would. However, it appears that, in the IRS' view, a seller of a partnership interest does not get foreign tax credits in respect of a §751 inclusion, even if traceable to an "as if" §1248 pick-up. The reason appears to be the IRS' reading of §1248(g)(2), which provides that §1248 does not apply to "any amount to the extent that such amount is, under any other provision of this title, treated as — (A) a dividend … , (B) ordinary income, or (C) gain from the sale of an asset held for not more than 1 year."
The foregoing language could be read as a trumping rule, such that whenever a taxpayer realizes ordinary income §1248 ceases to apply. If §1248 ceases to apply, there is no distribution or dividend that can carry with it foreign taxes. This is the way that the IRS seems to interpret §1248(g)(2). In the Preamble to final regulations under §1248, Treasury and the IRS observed as follows:A commentator noted that §1.1248-1(a)(4) of the proposed regulations could be read to apply to the sale by a partner of its interest in a partnership holding the stock of a corporation. The Treasury Department and the IRS did not intend that interpretation because it would be contrary to section 1248(g)(2)(B). An amount that is received by a partner in exchange for all or part of its partnership interest is treated as ordinary income under section 751(a) and (c) to the extent attributable to stock in a foreign corporation as described in section 1248. Section 1248(g)(2)(B) provides that section 1248 will not apply if any other provision of the Code treats an amount as ordinary income. Accordingly, §1.1248-1(a)(4) in the final regulations is revised to clarify that a foreign partnership is treated as an aggregate for this purpose only when a foreign partnership sells or exchanges stock of a corporation.
Putting aside the fact that nothing in the final regulation actually says what the Preamble does, and that the regulation is by its terms limited to foreign partnerships, this reasoning is extremely weak. If one takes §1298(g)(2) literally, as the preamble does, then §751(c) would never apply where the partnership interest sold is an interest in a foreign partnership. A foreign partnership is never subject to §1248. It is only under the §1248 regulations just summarized that a U.S. partner of a foreign partnership can be deemed to have sold stock of a CFC owned by a foreign partnership. If those §1248 regulations do not apply, there is no deemed sale and nothing for §751(c) to apply to.
If §1248(g)(2) applies to turn off the application of §1248 to the sale of an interest in a partnership owning a CFC, it appears that the buyer of the partnership interest, who has indirectly purchased CFC stock, would not be allowed to treat the seller's phantom §1248 inclusion as giving rise to previously-taxed income (PTI). This contrasts with the normal manner in which §1248 operates: any E&P taken into account by the seller as a dividend becomes PTI and cannot be taxed again to the buyer when distributed.6 It thus appears that the E&P of the CFC remains non-PTI and has not been deemed distributed to anyone. This will result in the double taxation of the same E&P when the CFC makes a distribution to the buyer, a result that certainly should not be deemed to have been intended by Congress.7
Imagine that the sale of a partnership interest is described in Rev. Rul. 99-6. That ruling, based on the McCauslen case,8 states that where the sale of a partnership interest results in the termination of the partnership, e.g., where all partners sell to a single buyer, the selling partner is treated as selling a partnership interest but the purchaser is treated as purchasing partnership assets. From the buyer's viewpoint, it has purchased stock of a CFC. There is no reason to believe that the buyer's direct purchase treatment should not control the question of how the CFC's E&P should be accounted for. The buyer would seem to be in a reasonable position to claim that any amount taken into account by the seller in respect of the deemed §1248(a) inclusion under §751(c) should result in such E&P being
treated as PTI.
To demonstrate why the IRS's position cannot possibly be correct, further imagine that the buyer makes a §338(g) election with respect to the purchased CFC in a Rev. Rul. 99-6 fact pattern. When Rev. Rul. 99-6 applies to a sale of a partnership interest in a partnership that owns a CFC, the buyer may make a §338(g) election with respect to the qualified stock purchase of the CFC.9 The election will result in enhanced E&P if the CFC realizes gain on the deemed sale of its assets. It appears that such enhanced E&P is taken into account by the seller under §751(c), given the "as if the partnership had sold" phrasing. This, of course, makes a bad situation worse if the seller cannot take any foreign tax credits and the buyer does not get the benefit of PTI.
But note that the §338(g) election causes any E&P of the CFC target to disappear, because "new target" is deemed to purchase assets from "old target."10 Going forward, the new target has no E&P. In a normal §338(g) acquisition, the old target's E&P is taken into account by the seller – in the case of a CFC, as a §1248 dividend inclusion. But where the seller is a partner who sells her partnership interest in a Rev. Rul. 99-6 context, the partnership hasn't sold anything and certainly has no E&P inclusion or §1248 dividend. Moreover, the actual seller – the seller of the partnership interest - won't be picking up the enhanced E&P under §1248, at least according to the IRS's theory of the case. The most one could say is that the seller is picking up ordinary income under §751. But under the IRS's view, the E&P hasn't come out of the CFC by reason of the §751 pickup.
So where did the target CFC's E&P go? It cannot have gone to the partnership, which hasn't in fact sold anything and in any case is not a taxpayer. It cannot have gone to the buyer; that is not the way §338(g) operates. If it is not taken into account by the selling partner, but disappears in the §338 mechanic, the E&P has seemingly disappeared without being taken into account by anyone.
At the beginning of this commentary, I noted that there are several possible culprits for this obviously incorrect result. While Rev. Rul. 99-6 can certainly be criticized (and has been), it is the symptom, not the disease. The real problem here is the IRS's apparent position - taken only in a very unclear Preamble in response to a suggestion that had nothing to do with the issue here – that §1248 does not in fact apply to a sale of a partnership interest. That position conflicts with the words of §751(c), which posits a hypothetical sale of CFC stock. That position is certainly not required by the language of §1248(g)(2), which could be interpreted by the IRS to turn off §1248 only where it would be prejudicial to the taxpayer to apply it. Section 1248 should be turned back on, consistent with the statutory scheme and other IRS pronouncements. Whatever §1248(g)(2) was intended to accomplish, it should not be interpreted so as to override the normal consequences of a §1248 sale deemed to occur by reason of §751(c).
1 1999-1 C.B. 432.
2 Section 1248(a) applies where a U.S. person (which could be a U.S. partnership or a U.S. partner of a foreign partnership) sells stock of a foreign corporation if the seller owned or was treated as owning, at any time during the previous five years when such foreign corporation was a CFC, at least 10% of the foreign corporation's voting stock. For simplicity, this commentary assumes that the foreign corporation is always a CFC as to any relevant U.S. person.
3See also Reg. §1.751-1(c)(4)(iv).
4 Reg. §1.1248-1(a)(4).
5 §902(c)(7); Rev. Rul. 71-141, 1971-1 C.B. 211; Rev. Rul. 69-124, 1969-1 C.B. 203. Note that where the partnership is a domestic partnership owning at least 10% of the voting stock of the CFC, a corporate partner does not need to own 10% or more indirectly in order to qualify for the §902 credit. See Reg. §1.1248-1(a)(1).
7 A similar problem arose under proposed regulations under §1411. Commentators noted the problem (see, e.g., Blanchard and Bower, "The Application of §1411 to Income from CFCs and PFICs," 42 Tax Mgmt. Int'l J. 127 (Mar. 8, 2013)) and it was remedied when the regulations were finalized. SeeT.D. 9644 (Dec. 2, 2013).
8McCauslen v. Commissioner, 45 T.C. 588 (1966).
9 In order to be a qualified stock purchase, the usual requirements would need to be met, including generally that the buyer not have a previous interest of more than 20% in the CFC.
10 Reg. §1.338-1(a)(1), §1.338-1(b).
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