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 January 28
IRS Issues Final Regulations on Partnership Audit Rules
Putting a New Spin on Things: Treasury Guidance Signals a Change for Tax-Free Spin-Offs
IRS Issues Final Regulations on Partnership Audit Rules
By Liz McGinley and Steven Lorch
On December 21, 2018, the Treasury Department and IRS released final regulations (the Regulations) implementing the federal audit regime for partnerships, and entities classified as partnerships for federal income tax purposes, enacted under the Bipartisan Budget Act of 2015 (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.
The Regulations adopt portions of the proposed regulations issued in August 2018 (the August Proposed Regulations), with limited revisions in response to the scores of written comments received by the Treasury Department and statements made in public hearings. In addition, the Regulations and the preamble to the Regulations (the Preamble) provide insight into the IRS’s view on several topics previously discussed in the Bracewell Tax Report, including the election pursuant to Code Section 6226(a) (the Push-Out Election), the alternative procedure for filing amended returns (the Pull-In Procedure), and the IRS’s authority to determine when a partnership ceases to exist for purposes of the New Rules.
The Treasury Department and IRS received extensive comments concerning the timing and mechanics of the Push-Out Election. Commenters advocated for an extension of the 45-day election period, including a recommendation that a partnership not be required to make the Push-Out Election until after a final determination of the partnership adjustments, and a recommendation that the Regulations permit an extension of the election period, either automatically or by request of the partnership. Commenters also recommended that partnerships should have the flexibility to revoke a Push-Out Election in the event of a change in circumstances after the election is made, including the settlement of an imputed underpayment.
The Treasury Department and IRS, however, declined to modify the period for making the Push-Out Election, which will remain the 45-day period after the final partnership adjustment is mailed to the partnership. The Preamble states that this 45-day period was established by statute and therefore would not be modified by the Regulations. Accordingly, the Regulations defer to Congress to make any substantive changes to the election period. Further, the Treasury Department and IRS declined to adopt comments requiring the IRS to notify a partnership of an invalid election, and declined to adopt Tax Court review of a determination that an election is invalid.
Commenters also recommended that the Push-Out Election be mandatory in two circumstances to mitigate a partnership representative’s potential conflict of interest: (1) if the partnership representative is both a partner in the reviewed year and the adjustment year, and the partnership representative’s interest during the adjustment year is less than in the reviewed year, and (2) if the aggregate partnership interest of any adjustment year partner, or partner group, holding a 20 percent or greater interest in the partnership, is 20 percent or greater than the interest held by the same partner, or partner group, in the reviewed year. The Preamble explains that such comments are inconsistent with the elective nature of the Push-Out Election under the Code, and therefore were not adopted. Notably, by rejecting this comment, the Treasury Department declined to extend mandatory Push-Out Elections beyond situations where a partnership ceases to exist, as discussed below, and, consistent with the general structure of the New Rules and associated regulations, refused to insert itself into potential disputes among partners, which instead will be governed by the provisions of the applicable partnership agreement.
The Treasury Department and IRS received several comments concerning the Pull-In Procedure, which was introduced in the Technical Corrections Act of 2018 as an alternative to modifying an imputed underpayment by partners amending their reviewed year tax returns. One commenter recommended that partners participating in the Pull-In Procedure be permitted to communicate directly with the IRS exam team during the partnership audit, rather than communicating through the partnership representative or its agent, and thereby avoiding sharing the details of their respective financial affairs with the partnership representative or the partnership. The Preamble declined to address this comment in the Regulations, but noted that the procedures for gathering partners’ information for purposes of the Pull-In Procedure were still forthcoming, and such processes may permit partners to provide certain information directly to the IRS.
In addition, in response to comments that partners should be able to claim a refund in connection with the Pull-In Procedure, the Treasury Department and IRS responded that the Pull-In Procedure, in contrast to modification by amendment, was intended to be a streamlined process available only to partners that make a payment, or owe no tax, with respect to an imputed underpayment. Partners may utilize the Pull-In Procedure if they have been allocated negative adjustments, but only if those adjustments would offset other positive adjustments, and otherwise must file an amended return in order to claim a cash refund.
Partnership Ceasing to Exist
The August Proposed Regulations provided that, if the IRS determines, in its sole discretion, that a partnership ceases to exist before partnership adjustments take effect, the adjustments must be taken into account by former partners as if a Push-Out Election had been made for the reviewed year. For this purpose, the IRS could, but was not required to, determine that a partnership ceased to exist if no business, financial operation, or venture of the partnership continued to be carried on by any of its partners in a partnership (a Section 708(b)(1) Termination), or if the partnership does not have the ability to pay, in full, any amount due under the New Rules for which the partnership is or becomes liable. A Section 708(b)(1) Termination presumably would include the partners’ sale of 100% of their partnership interests to an unrelated buyer for cash. Practitioners were concerned that such broad discretion would make it difficult to predict whether, following various types of sale, merger or other transformative partnership transactions, partners should expect to be subject to a mandatory Push-Out Election or whether they would be free to choose another method under the New Rules. In response to this comment, the Regulations provide greater certainty to taxpayers by requiring the IRS to determine that a partnership ceased to exist in the event of a Section 708(b)(1) Termination or if the partnership is unable to pay amounts due under the New Rules. The IRS would retain complete discretion in other situations, however, including the partners’ sale of all or substantially all of their partnership interests.
Tax Return Consistency
The August Proposed Regulations were unclear as to whether a partner may file an amended return to take a position inconsistent with the filed partnership return. Commenters requested that the Regulations confirm that such an inconsistent position on an amended return is permitted, provided that the amended return include a statement identifying the inconsistent treatment, and the Treasury Department and IRS accepted this comment.
The Regulations apply to partnerships for taxable years beginning after December 31, 2017 and ending after August 12, 2018, as well as partnerships that make the election to apply the New Rules to partnership taxable years beginning on or after November 2, 2015, and before January 1, 2018.
Putting a New Spin on Things: Treasury Guidance Signals a Change for Tax-Free Spin-Offs
By Michele Alexander, Ryan Davis and Katherine Erbeznik
As we previously have explored (see here and here), recent tax reform under the Tax Cuts and Jobs Act (TCJA) has been particularly advantageous to corporations. However, the pro-corporate policies of the current administration have extended beyond the TCJA. This is evident in the context of tax-free spin-offs, where the Treasury Department has indicated its willingness to provide rulings that would increase certainty regarding the tax-free treatment of certain spin-off transactions, as well as its support for guidance that would make it easier to qualify for such treatment. This could have significant implications, particularly in industries such as energy that steadily are moving to corporate form in light of tax and regulatory reform, as well as technology companies – often in corporate form due to their heavy venture capital investor base – that to date might struggle to meet certain spin-off requirements.
In general, a corporation (Distributing) may distribute stock of either a new or “old and cold” subsidiary (Controlled) to its shareholders in a transaction that is tax-free to both Distributing and its shareholders under Sections 355, 361 and 368 of the Internal Revenue Code, provided that a complex set of rules is satisfied. While a full discussion of spin-offs and related requirements is beyond the scope of this article, generally the distribution must have a valid business purpose and not be merely a device to allow for the distribution of earnings and profits in place of a dividend. In addition, immediately after the distribution, each of Distributing and Controlled must be engaged in the active conduct of a trade or business (known as the active trade or business or ATB requirement) that has been conducted throughout a five-year period ending on the date of the distribution (and includes trades or businesses acquired in non-recognition transactions).
The question of when a business is “active enough” to satisfy the ATB requirement long has dogged corporations seeking to engage in tax-free spin-offs, particularly in technology and other research-intensive industries, where significant costs are incurred well in advance of revenues. Historically, the focus of the ATB requirement, specifically the determination as to the commencement of the applicable five-year period, has been on the production of income – while companies operating in such industries may not be income producing until years after incurring the necessary research and development (R&D) costs. Moreover, where the industry is funded by venture capital, there may be legitimate business reasons to separate competing businesses, which may not be achievable through tax-free spin-offs due to the significant timing differences between R&D phases and income generating activities.
Presumably to address this issue, the IRS released a statement in September saying that it was reevaluating the requirement found in the regulations under Section 355(b) that a business must collect income and pay expenses in order for it to be considered as engaged in an active trade or business.1 Notably, the role of R&D in the pharmaceutical industry is cited as the motivation for revisiting the issue. As noted above, during the potentially long periods of R&D required by this industry, a business may not generate revenue even though it undertakes expensive activities the sole purpose of which is to earn income in the future. As a result, Treasury Department is looking to expand the factors that may be included in analyzing whether an active trade or business has taken place during the applicable five-year period, such as the “incurrence of significant and regular expenses… statements holding the business out as an entity that will produce income, and other businesses similarly situated that have produced income.”2 While the immediate intended beneficiaries are those in the pharmaceutical industry, we expect any clarifying guidance to apply to any business with significant R&D costs, including technology that may support developing economic systems – and attract venture capital and other investment. While the ability to engage in a tax-free spin-off may not be at the forefront of a venture capital investor’s mind, many investment strategies contemplate exit scenarios before the first dollar is invested, and require flexibility to change structures to meet the needs of the business, including the ability to efficiently separate one or more businesses. Until now, entire industries effectively were limited by the current ATB requirement from seriously considering spin-offs as a business separation method unless they could wait until the five-year mark after becoming income producing – often a considerable delay from the five-year anniversary of commencing significant, but not income generating, R&D activity. This new approach by the Treasury Department, if implemented, could be a game changer for technology companies, even if not obvious from the announcement or immediate reaction.
The Treasury Department also is hoping to continue and expand a pilot program it initiated in September 2017, which sought to provide greater assurance to taxpayers that their transactions would qualify as tax-free by granting them Private Letter Rulings (PLRs) blessing a proposed spin-off. This punctuates a long history of limiting and then potentially expanding situations in which the IRS would rule on spin-offs. Specifically, in Revenue Procedure 2013-3 the IRS announced that it no longer would rule on whether Section 355 or Section 361 (providing for non-recognition of corporate parties to reorganizations, including divisive reorganizations) applied to Distributing’s distribution of Controlled stock or securities in exchange for (and in satisfaction of) Distributing’s debt. This particularly was relevant in light of a common practice in which investors would purchase debt of Distributing on the market (or newly issued debt) with a view of exchanging such debt for stock or securities of Controlled (or other property received by Distributing from Controlled in the spin-off) in a tax-free exchange in connection with a planned spin-off. Most investors abided by the substance of the so-called “5-14” representation that the IRS required when ruling on these types of transactions – i.e., the investor (typically, an investment bank) would acquire the Distributing debt (either newly-issued or on the market) at least five days before entering into an agreement with Distributing to exchange the debt for stock or securities (or other property) and to hold the debt for at least 14 days before closing on such exchange.
The announcement in 2017 signaled a reversal of this no-rule position. Then, in October 2018, Revenue Procedure 2018-53 was released in order to standardize the process by which taxpayers can request rulings regarding the exchange of Distributing debt in connection with a spin-off, thereby increasing the certainty surrounding both the PLR process and the tax-free nature of the hypothetical transaction. Revenue Procedure 2018-53 describes the relevant information that should be provided by the taxpayer to the IRS in order for a PLR to be provided, including a description of (1) the debt that will be distributed and assumed or satisfied (including the relevant terms and the date it was incurred); (2) the consideration that will be distributed to creditors in satisfaction of the debt; and (3) the transactions that will implement the assumption or repayment of the debt. In addition to this information, the revenue procedure stipulates seven specific representations that Distributing must make when submitting a PLR request. These are:
Distributing is the obligor of the debt that is to be assumed or satisfied;
no holder of the debt that will be assumed or satisfied is a person related to Distributing or Controlled currently owing the debt;
the holder of the debt will not hold the debt for the benefit of Distributing , Controlled, or any related person;
Distributing incurred the debt (a) before the request for any relevant ruling is submitted and (b) no later than 60 days before the earliest of (i) the first public announcement of the reorganization, (ii) the entry by Distributing into a binding agreement to engage in the reorganization, and (iii) the date of approval of the reorganization by the board of directors of Distributing;
the total adjusted issue price of the debt that will be assumed or satisfied does not exceed the historic average of the total adjusted issue price of certain other debt obligations of Distributing;
the substantial business reasons for any delay in satisfying the debt with consideration received by Distributing from Controlled pursuant to Section 361; and
Distributing will not replace any debt that will be assumed or satisfied with previously committed borrowing, other than borrowing in the ordinary course of business.3
In addition to providing the IRS with the information necessary to make a ruling, these representations provide taxpayers with a list of factors that may help their transactions qualify as tax-free. Notably, the 5-14 representation does not appear anywhere. The significance of this is unclear, with one view being that absent a direct repudiation of the rule commonly used in practice, it still stands. Another view is that absent the requirement of the 5-14 representation in the new guidance, there is no requirement that the debt be held by an investor for any time at all prior to the signing of the exchange agreement or the closing of the exchange. In the authors’ view, the latter is an extremely liberal interpretation of the new guidance (and the absence of such representation), but pending further guidance it may not be unreasonable to assume that compliance with the principles of the 5-14 rule is sufficient to address current IRS concerns about investor holding periods. Similarly, the view that the 5-14 representation was insufficient to address the risk, and that we will see further guidance as to what the IRS now views as acceptable, is in our view an overly conservative take on the new guidance. Note, however, the representation above that Distributing now must make regarding the timing of incurring the debt and entering into the transaction. Although a representation focusing on the timing of the debt incurrence (and relatedness of the parties to Distributing/Controlled and any intermediaries) could be a replacement for the 5-14 representation (which focused more on the investor’s holding period), as of now the status of the 5-14 representation and its related practice is unclear at best. The most practical approach simply may be to follow the new guidance pending clarity on this point.
Nevertheless, these announcements by the IRS – on debt exchanges in particular – bode well for investors and corporations alike. That said, both announcements are early stage, and corporations and investors alike may not see significant changes in market practice pending further development.
2 Michael J. Bologna, Keeping Asking About Tax-Free Spin-Offs, Bloomberg Law, https://www.bloomberglaw.com/ (last visited Jan. 28, 2019).
3 Revenue Procedure 2018-53
The Bracewell Tax Report will be distributed on a regular basis. Upcoming topics will include:
Recent Developments Affecting Renewable Energy Tax Credits
Impact of Tax-Exempt Investors in Private Equity Structures