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 (TCJA), 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.
The New Partnership Audit Rules, Part 1: The Basics
By Liz McGinley and Steven Lorch
This is the first of several installments of Bracewell Tax Report articles describing the new rules applicable to partnership audits under the Internal Revenue Code, and related proposed and final Treasury regulations. Future installments will focus on various aspects of these rules and 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 tax purposes (the "New Rules"). The New Rules, effective for audits of partnership tax years beginning on or after January 1, 2018, are a dramatic departure from the prior rules, known as the TEFRA rules (the "TEFRA Rules"). Under the TEFRA Rules, the IRS is required to allocate any partnership audit adjustments among the partners in the year subject to audit, and assess and collect any underpayment of tax at the partner level. Accordingly, audits under the TEFRA Rules require substantial IRS resources, causing audits of large partnerships, with hundreds, or even thousands, of partners extremely difficult and time consuming for the IRS. In contrast, under the New Rules, the IRS is permitted to impose any underpayment directly against the partnership. The burden of allocating the adjustments or underpayment among the partners therefore is shifted to the partnership. Accordingly, with the potential for increased efficiency conducting partnership audits under the New Rules, it is anticipated that the IRS will more vigorously pursue large partnership audits.
Under the New Rules, the imputed underpayment is calculated by multiplying the net positive audit adjustment to taxable income of the partnership by the highest marginal federal income tax rate (individual or corporate, as applicable) in effect for the tax year subject to audit (the "Reviewed Year"). The partnership, however, can request modifications of the imputed underpayment computed by the IRS including by demonstrating that (i) partners in the Reviewed Year amended their tax returns including the Reviewed Year to reflect their share of the adjustments and paid the related tax due, (ii) a portion of the adjustments are properly allocable to a partner not subject to tax or (iii) a portion of the adjustments are allocable to a corporate partner or properly treated as capital gain or qualified dividends allocable to an individual partner, in each case, subject to tax at a lower rate.
The imputed underpayment, adjusted for any modifications approved by the IRS, is assessed on the partnership, so the partners in the year the assessment is made bear the economic burden of the underpayment. Such result may be inequitable if the ownership interests of one or more partners in the partnership in the Reviewed Year differ from their interests in the partnership in the year the audit concludes and the assessment is paid. As an alternative to the partnership bearing the imputed underpayment in the year the audit concludes, the partnership can elect to push the audit adjustments out to the partners in the Reviewed Year (the "Push-out Election"). When the Push-out Election is made, each Reviewed Year partner is required to include its share of the audit adjustments in its current year tax return and pay any resulting increase in tax.
The New Rules also replace the designation of a tax matters partner under the TEFRA Rules with the designation of a partnership representative. Unlike the tax matters partner, the partnership representative need not be a partner in the partnership. Moreover, the New Rules grant the partnership representative broader authority to act on behalf of, and bind, the partnership and its partners than the tax matters partner. Accordingly, the other partners may seek restrictions in the partnership agreement on the partnership representative’s ability to make decisions binding on the partners as part of the audit process.
Finally, a partnership can elect to be excluded from the application of the New Rules (the "Election Out") if it has 100 or fewer eligible partners. Pursuant to final regulations recently issued by Treasury, individuals, C-corporations and S- corporations are eligible partners for this purpose, but partnerships and disregarded entities are not. As a result, any partnership with even a single partner that is a disregarded entity or partnership will be subject to the New Rules.
Our next installment will focus on partnership’s ability to make the Election Out, including tax planning and drafting techniques allowing partnerships and partners to permanently avoid the application of the New Rules.
Final Foreign Partnership ECI
By Michele Alexander and Ryan Davis
While much has been made about international tax reform contained in the Tax Cuts and Jobs Act ("TCJA") that modifies the taxation of U.S. taxpayers with multinational holdings and operations, the new law did not leave inbound investment untouched. Notably, the TCJA codified a published ruling in a fairly controversial area of partnership tax law, in a potential disappointment to non-U.S. investors in domestic partnerships and practitioners who questioned the authority for issuing the ruling in the first place.
By way of background, foreign persons generally are subject to tax on income effectively connected with the conduct of a trade or business within the United States ("ECI") in the same manner as U.S. persons. ECI generally is not subject to withholding, but special rules require partnerships to withhold with respect to allocations of ECI to their non-U.S. partners. In Revenue Ruling 91-32 (the "Ruling"), the IRS held that a foreign partner has ECI to the extent the gain is attributable to ECI-producing assets. ECI-producing assets were defined as those belonging to a partnership that is carrying on a trade or business in the United States through a fixed place of business.
While practitioners and taxpayers alike typically rely on published rulings, this one was controversial from the start.1 The uncharacteristic amount of opposition to the ruling was due to disagreement over whether the Treasury had the authority to treat such gain as ECI; otherwise, under the Internal Revenue Code (the "Code"), the sale of a partnership interest generally was treated as the sale of a capital asset (with the only exceptions in the Code being for receivables and so-called "hot" assets), and before the TCJA there arguably had been no path in the Code for the IRS to add other exceptions. While there often is tension in partnership taxation between treating the partnership as an entity versus an aggregate of its partners, practitioners opposing the ruling argued (rather persuasively) that the IRS could not rule in a manner that was inconsistent with a Code Section and treat the sale of a partnership interest as anything other than the sale of a unitary capital asset, no different than stock in a corporation (except to the extent the Code already provided grounds to "look through" to the underlying assets, such as hot assets).
The TCJA codification likely was sparked by the Tax Court ruling in Grecian Magnesite which, in a direct repudiation of the Ruling, stated that the gain from a foreign partner's sale of a capital asset should be sourced to such partner’s country of residence (click here for more). Under the TCJA, new Code Section 864(c) states that ECI is to be treated in the same manner as if the partnership had sold the assets generating ECI and allocated the gain to the partner. Moreover, in calculating the taxable gain of a foreign partner of a partnership that is engaged in a U.S. trade or business, the new provision states that any gain on the disposition of a partnership interest will be presumed to be U.S. source ECI gain and any loss will be presumed to be foreign source non-ECI, unless the partner is able to produce evidence demonstrating otherwise.
Significantly, the new law also imposes a withholding tax at a flat 10% rate on the amount realized on the sale or disposition of the interests. The new provision (Code Section 1446(f)) allows the IRS, at the request of the transferor or transferee, to reduce the amount of withholding if it will not jeopardize the collection of the tax imposed, though notably there is no specific procedure yet in place for foreign partners to obtain such a reduction. What’s more, if the purchaser of the interest in question fails to withhold the proper amount of tax, the responsibility falls to the partnership itself.
Arguably, the enactment of new Code Section 864(c) resolves the primary concern of those who opposed the ruling, as Congress has the power to create new tax law on par with Section 741, and to create an exception to the treatment provided for therein. However, even for those who agree with the substance of the ruling, the withholding obligation, which currently provides little guidance as to the procedure the seller must follow in order to avoid or mitigate, will cause practical concerns, as will the burden to prove the nature of losses. Compare this to the process outlined in the Foreign Investment in Real Property Tax Act ("FIRPTA"), which Treasury should consider when working on procedures (if any) for collecting and remitting the new ECI withholding tax. That process allows the seller to apply for a withholding certificate in order to reduce the required withholding to the foreign investor’s actual tax liability – or provide a notice of nonrecognition transfer to prevent withholding entirely in certain reorganizations and contribution transactions. Even if the withholding certificate is not received in time, the buyer does not have to remit the withheld amounts if the application is filed before closing/sale. Moreover, the notice of nonrecognition need only be presented before the closing and a copy filed with the IRS within 20 days of the transfer. Presumably, Code Section 1446(f)(3) will provide the IRS with the authority to promulgate similar procedures for new Code Section 864(c). Otherwise, foreign investors may be forced to file federal income tax returns to obtain a refund of amounts withheld in excess of their actual tax liability. Many foreign investors are reluctant to file tax returns in the United States revealing personal identifying information where their only connections are, in some cases, isolated investments. This may drive foreign investors to invest in partnerships that are expected to generate ECI through so-called blocker corporations in order to be protected from the taint of ECI as well as the need to personally file tax returns.
As we discussed (here), blocker corporations cleanse the "taint" of ECI, but at the cost of entity-level tax. However, the entity-level tax on blockers is now less onerous with the new 21% rate (a 40% reduction from the prior corporate rate of 35%), and blockers now have more flexibility to leverage with related party debt following the repeal of the so-called "earnings stripping" rules (see here), though they likely would be impacted by the new limit on interest deductions (generally, to the sum of interest income and 30% of taxable income (see here)). This may be particularly attractive to investors in private equity type investments who tend not to rely on the payment of dividends (which creates a second level of tax), but rather realize their full return on investment upon exit.
To the extent that the Act ever was touted as a way to level the playing field for inbound investors, the codification of the Ruling – coupled with the way in which FIRPTA was left completely intact despite sweeping international tax reform otherwise – signals that making the United States a more attractive investment opportunity was not as high of a priority for lawmakers as was previously believed. Interestingly, even though many of the significant international tax law changes in the TCJA addressed OECD concerns on base erosion, they mostly were targeted at preventing U.S. companies from artificially reducing U.S. federal tax – and the new so-called "territorial" tax system only benefits U.S. corporations. Given the current administration's "America First" slogan, it may not be a coincidence that the only change directed at non-U.S. investors put them at a competitive and practical disadvantage to domestic investors.
1 See Blanchard, "Rev. Rul. 91-32: Extrastatutory Attribution of Partnership Activities to Partners," 76 Tax Notes 1331 (9/8/97).
Prepaid Power Contracts
By Vivian Ouyang and Liam Donovan
Some renewable projects, especially solar projects, use prepaid power contracts. Under a prepaid power contract, the offtaker enters into a long term contract with the supplier to buy electricity. Upon the closing, the offtaker prepays the supplier for a portion of the electricity to be delivered under the contract.
Before the Tax Cut and Jobs Act ("TCJA"), if the prepayment is properly structured, the supplier of the electricity may be able to defer the inclusion of the upfront payment for income tax purposes. Instead of reporting the full prepayment as its taxable income upon the receipt of such prepayment, the supplier was allowed, before the enactment of the TCJA, to take the prepayment into income only as and when the performance for such prepayment occurs, i.e. when electricity is delivered to the offtaker in the future under the contract. That resulted in a deferral benefit to the supplier because the supplier received cash payments upfront, but reported taxable income much later, typically over the course of the prepaid power contract.
The TCJA disallows such deferral benefits from prepayments for "goods and services" identified by the IRS. The TJCA requires a prepayment for such "goods and services" to be reported immediately as income, or at best, partly in the year the prepayment is received and the balance in the year immediately thereafter. Even though the IRS has not issued guidance to identify such "goods and services", since electricity has been treated by the IRS as "inventoriable goods", it is expected that prepaid power contracts for the delivery of electricity will be affected by the TCJA.
Before the enactment of the TCJA, the tax benefits of prepaid power contracts enabled developers to reduce the cost of capital for renewable energy projects. The changes imposed by TCJA likely would affect the pricing on prepaid power contracts, and incentivize developers to find alternative sources of capital.
IRS Would More Easily Audit Large Partnerships Under Proposal
The Game Has Changed: Partnerships Could Be Subject To Income Tax Under New Partnership Audit Rules
The Bracewell Tax Report will be distributed on a regular basis. Upcoming topics will include:
Electing out of the new partnership audit rules.
Tax-exempt use property: the impact of super tax-exempt investors in pass-through structures
Outlook for the extension of the 80% PTC/ITC carve-out from BEAT beyond 2025 and the effects of the partnership termination rules on renewable energy projects
Current tax issues impacting the technology and media space.