The Bracewell Tax Report is a periodic publication focused on developments in federal income tax law, including the recently enacted Tax Cuts and Jobs Act, with emphasis on how such developments impact the energy, technology and finance industries. The publication provides summaries of changes in tax law and its interpretation, as well as related practical guidance critical to making strategic business decisions and negotiating transactions.

Week of April 23

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Featured Articles

The New Partnership Audit Rules, Part 4:  The Partnership Representative
By Liz McGinley and Steven Lorch

This is the fourth installment of Bracewell Tax Report articles describing the new rules applicable to partnership audits under the Internal Revenue Code and the related proposed and final Treasury regulations. Each installment focuses on certain aspects of these rules and the practical implications to partners and partnerships, particularly as they relate to negotiating and drafting partnership agreements. 

On November 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015, which included a new federal audit regime for partnerships and entities classified as partnerships for federal income tax purposes (the New Rules). The New Rules, effective for audits of partnership tax years beginning on or after January 1, 2018, generally allow the IRS to adjust items of income, gain, loss, deduction or credit of a partnership, and collect any resulting underpayment of tax, at the partnership level. Click here for a general description of the New Rules. 

Under the New Rules, a partnership must designate a partner, or other person, with substantial presence in the United States to serve as the partnership representative. If the partnership representative is an entity, the partnership representative must appoint an individual, known as the designated individual, through whom it will act for all purposes under the New Rules. The partnership representative has the sole authority to act on behalf of the partnership, and legally bind the partnership, with respect to federal examinations and audits. No contractual arrangement, including any partnership agreement or state law document, can limit or alter this authority. In addition, other than the partnership representative, no partner or other person may participate in any examination or other proceeding with the IRS. 

The role of the partnership representative represents a broad departure from that of the tax matters partner under the prior partnership audit regime, commonly known as the TEFRA rules. The TEFRA rules required that the tax matters partner be a partner in the partnership that satisfied certain criteria, which, particularly in the case of complex partnerships, often were difficult to apply. In the event a partnership did not properly designate a tax matters partner, the TEFRA rules required a partner to be assigned to the role, either pursuant to statutory rules or by the IRS, before a federal partnership audit could begin. Finally, the TEFRA rules required the tax matters partner to give notice to the other partners of examinations and audits, and permitted other partners to be present and participate directly in relevant proceedings.

For most partnerships, the choice of partnership representative is a straightforward decision that is made without significant negotiation. Very often, a controlling or majority partner is the natural choice, particularly if that partner has effective control over the operation of the partnership. In other partnerships, a minority partner responsible for day-to-day administration of the partnership or with the greatest knowledge of the partnership’s business and operation may be best suited for the role. In certain situations, however, it can be difficult to find any partner willing to take on the role and responsibilities of the partnership representative. When the New Rules were first signed into law, it was expected that many partnerships would outsource the partnership representative role to outside advisors for a fee. Some commentators even believed a new industry for partnership representative services would emerge, although this has not yet been the case.

Under the New Rules, a critical issue among partners often is how much authority to vest in the partnership representative, and whether to give the other partners a role in the partnership representative’s decision-making process. Particularly if the partnership representative is a partner with effective control of the partnership or management responsibility for day-to-day operations, this partner may seek an unfettered right to make decisions with respect to partnership examinations and audits at its sole discretion. In response, other partners may request notice of the initiation of a partnership examination or audit, and the right to be kept reasonably informed with respect to these matters by the partnership representative, because these rights are not guaranteed under the New Rules. In addition, these partners may seek the right to consult with the partnership representative on key decisions, determinations and elections related to an examination or audit, and may even ask for a prohibition on certain actions by the partnership representative without such partners' consent. However, a partner serving as a partnership representative should be cautious with respect to broad consent rights. Such consent rights could cause a deadlock among partners, which could delay the orderly administration of a partnership audit or even cause the partnership representative to miss a deadline imposed by the New Rules or the IRS. An alternative approach is to put these key decisions, determinations and elections in the hands of the partnership’s board or other governing body, although this may not necessarily eliminate the risk of deadlock or delay. 

When drafting partnership agreements, partners often focus on procedures relating to the push-out election. If made, the push-out election permits audit adjustments to be allocated to the partners in the year under review as an alternative to the current year partners bearing the resulting assessment. (Click here for more on the push-out election.) Timing is of the essence for making the push-out election, which must be made no later than 45 days after the IRS mails the notice of final audit adjustments to the partnership. Accordingly, the partnership representative likely will prefer to have full control over the decision to make the election, if not a binding mandate in the partnership agreement to make the election in all instances, rather than seek the consent of, and potentially negotiate with, the other partners. From the other partners’ perspective, the decision to make a push-out election for an imputed underpayment can materially impact their cash tax liability and, therefore, these partners may negotiate for a consent right that will survive the partners’ exit from the partnership. 

Our next installment will focus on the “pull-in” election under the New Rules, which was rolled out as part of the recent Consolidated Appropriations Act, 2018.

From Hollywood to the Gray Lady: The Impact of Tax Reform on Film, Television and Print Media - Part 3
By Michele Alexander and Ryan Davis

As we have noted in past reports, tax reform is impacting the media industry in a number of important ways (click here and here for more).  In this installment, we further explore new international and domestic provisions that will impact media companies’ decisions regarding foreign versus domestic production. 

Unlike many of the country’s largest technology companies, media and entertainment companies generally did not benefit from inversions and other pre-tax reform practices that reduced their overall U.S. tax bill.  However, they still find themselves casualties of the Tax Cuts and Jobs Act (TCJA) efforts to curb the parking of valuable assets, and payment of significant cash amounts, offshore.  In order to encourage the return of valuable assets and capital to the United States, the TCJA provides for a low one-time repatriation tax on income previously kept offshore (15.5% on foreign cash and other liquid assets and 8% on all residual assets, in each case, to the extent of earnings and profits).  Although the tax is intended as short-term encouragement for the return of capital to the United States (as it is imposed whether or not cash actually is repatriated), this also could act as a longer-term incentive for keeping domestic media production onshore.  This longer-term domestic benefit is reinforced by other new provisions found in the TCJA.  The new Base Erosion Anti-Abuse Tax (BEAT) complements the repatriation tax by providing an incentive for American companies to hold assets onshore by doing away with the primary benefit they derived from not doing so – specifically, the avoidance of U.S. federal taxation.  The new provision accomplishes this by limiting the deductibility of payments to foreign affiliates in lower-tax jurisdictions by U.S. taxpayers (click here for more).  The BEAT generally requires corporations with average annual gross receipts of $500 million to pay a tax on deductible payments made to foreign affiliates equal to 10% for years before 2025, with a phase in at 5% for 2018.  While worldwide media companies do not appear to be the intended target, larger media enterprises may find themselves within the ambit of BEAT and thereby motivated to bring certain activities onshore.  Of course, there are significant, often competing non-tax considerations for media/entertainment and film production companies, as location may very well impact production and finished product.   

Similarly, the global intangible low-taxed income (or GILTI) tax targets American companies that continue to hold intangible assets offshore while maintaining the majority of their operations domestically. This could have a particularly important impact on U.S. media companies, which want to reap the benefits of being located in certain U.S. markets with notable advantages (such as New York or Los Angeles) while still being able to mitigate their tax burden by holding valuable copyrights or licenses abroad.  However, just as in the case of BEAT, many international media and entertainment companies have legitimate non-tax reasons for holding these intangibles abroad, particularly in jurisdictions where filming and production actually take place.  The new tax undermines this tax maneuver – but also disadvantages this latter category – by requiring U.S. shareholders holding at least a 10% share of a controlled foreign corporation to include in gross income for the tax year such corporation’s income from intangible assets held abroad that otherwise would not be taxable in the United States (click here for more).  Although the FDII deduction (discussed below) may allow corporations to reduce their tax burden with respect to intangibles, this likely will lead U.S.-based media companies to reevaluate whether it remains profitable to keep these intangible assets abroad – but also to consider bringing activities onshore where the new status quo subjects even “innocent” media companies to the tax.

As a practical offset to the GILTI tax, the TCJA provides a new incentive for U.S. companies to provide goods and services to foreign markets by allowing domestic corporations to take deductions on their so-called foreign-derived intangible income (FDII).  This deduction only is available to U.S. entities classified as corporations for tax purposes (including domestic corporate subsidiaries of foreign companies) – which provides a disproportionate boon to the media industry – and is determined using a complex calculation (which we will discuss more in-depth in later installments).  A domestic corporation’s FDII is 37.5% deductible (to the extent it has taxable income), which yields a 13.125% effective tax rate (the new 21% corporate rate multiplied by 37.5%) and may be further reduced with foreign tax credits where applicable. It should be noted, however, that for tax years beginning after December 31, 2025, the effective tax rate on FDII increases to 16.406%. As noted above, the FDII provision also reduces the tax rate on GILTI by 50% to an effective rate of 10.5% (increasing to 13.135% in 2026).  One consequence of this provision is that it provides a tax incentive to earn income from the sale of property and services to persons outside the United States, even though media companies otherwise may have these streams without regard to tax. As a result, a number of countries have threatened to challenge the legality this provision at the World Trade Organization under the theory that it provides an export subsidy to domestic corporations.  At the same time, media and technology companies are undertaking detailed review of their tax projections taking into account GILTI and FDII – as we will explore in greater detail in future installments, it seems like a “mixed bag” within the industry as to how much the GILTI will sting, and how much the FDII will mitigate.  

In addition to encouraging (or coercing) domestic media companies to return capital and investment to the United States, the TCJA also may spur new investment from non-U.S. investors. Specifically, the significantly lower corporate rate could encourage investment from foreign companies (and other types of foreign investors) that had previously refrained from doing so due to the relatively high U.S. corporate tax rate.  It is possible that prior to the law’s passage, potential television and film investors outside of the United States were hesitant to invest in productions without the presence of corporate blockers.  However, blockers were viewed as unattractive options due both to the entity-level rate of taxation and the former so-called earnings stripping rules, which limited interest deductions for related party debt (click here for more).  Now the TCJA has repealed the earnings stripping rules and, at the same time, one of the largest drawback to using blockers – the entity level tax to which they are subject – now is mitigated by the aforementioned decrease in the corporate tax rate (from 35% to 21%).  Particularly where the investment strategy does not rely on dividend payments, blockers actually may be a more attractive option following tax reform.  In particular, private equity funds with a media focus may consider more U.S. investment, particularly since traditional fund investment does not contemplate dividend payments.  

The alleviation of these concerns with corporate blockers also may encourage potential foreign investors in media to use them, or switch to them from an investment in media partnerships or joint ventures structured as partnerships for tax purposes.  This is specifically due to the way in which the TCJA codified a controversial IRS ruling and subjected non-U.S. persons selling partnership interests to tax and withholding on so-called “effectively connected income” (ECI) to the extent that the gain from such disposition is attributable to ECI-producing assets (click here for more).  While there has been some preliminary guidance issued on the withholding obligation, in general it may cause practical concerns, as foreign partners attempting to invest domestically may be forced to file federal income tax returns in order to obtain a refund of amounts withheld in excess of their actual tax liability.  This may drive foreign investors to invest in media partnerships that plan to utilize blocker corporations in order to protect the foreign investors from both the taint of ECI and any personal reporting requirements to the IRS.

Additional Reading

The Game Has Changed: Partnerships Could Be Subject To Income Tax Under New Partnership Audit Rules