Treasury issues Section 956 guidance for partnership transactions

On September 1, 2015, due to the Treasury Department and the Internal Revenue Service (the "IRS") becoming aware that taxpayers may be using partnerships to avoid inclusions under Section 956 of the Internal Revenue Code of 1986, as amended ("Section 956"), the Treasury Department and the IRS issued temporary regulations (TD 9733) (the "Temporary Regulations") that expand and create new rules to cover certain transactions involving partnerships.  On the same date, the Treasury Department and the IRS also issued proposed regulations (REG-155164-09)(the "Proposed Regulations") that address and provide guidance on the treatment of obligations of and "United States property" held by a foreign partnership for purposes of Section 956. 

The following contains a general summary of Section 956 and certain of the material rules and guidance set forth in the Temporary Regulations and the Proposed Regulations.

Background

In general, a U.S. shareholder of a controlled foreign corporation ("CFC") is not subject to U.S. federal income tax on the earnings and profits of the CFC until such earnings and profits are distributed to the U.S. shareholder.  There are certain exceptions to this general deferral rule, which are often referred to as "anti-deferral" rules.  One such exception, or anti-deferral rule, is contained in Section 956.   Section 956 generally causes a U.S. shareholder of a CFC to include in income the amount of "United States property" held, directly or indirectly, by the CFC up to the extent of such U.S. shareholder's share of the CFC's earnings and profits.  For purposes of Section 956, "United States property" includes, among other things, certain stock or obligations of a U.S. person and tangible property located in the United States.  Section 956 issues are often implicated in connection with financing transactions because the guarantee by a CFC of debt of a U.S. parent would cause the CFC to be considered to hold such debt under Section 956 and such debt would generally be "United States property."

The Treasury Department and the IRS determined that transactions involving partnerships were not adequately addressed under current Section 956 regulations and, therefore, issued the Temporary Regulations and the Proposed Regulations.

Summary of The Temporary Regulations

The Temporary Regulations made three primary changes with respect to Section 956.  First, the Temporary Regulations modified the existing anti-avoidance rule set forth in Temp. Treas. Reg. § 1.956-1T(b)(4) (the "Anti-Avoidance Rule").  Second, the Temporary Regulations expanded the Anti-Avoidance Rule to cover certain partnership situations.  Third, the Temporary Regulations created a new rule to cover certain foreign partnership distribution transactions that are funded by CFCs.  Such rules apply to taxable years of CFCs ending on or after September 1, 2015, and to taxable years of U.S. shareholders in which or with which such taxable years end, with respect to property acquired or in the case of distributions made on or after September 1, 2015.

Modification of the Anti-Avoidance Rule – Prior to the issuance of the Temporary Regulations, the Anti-Avoidance Rule provided that a CFC was considered to indirectly hold "United States property" if, at the discretion of the District Director, investments in "United States property" were acquired by any other foreign corporation that is controlled by the CFC and one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) such other foreign corporation was to avoid the application of Section 956 with respect to the CFC.  The Temporary Regulations modify this rule so that it will now apply when a foreign corporation controlled by a CFC is funded "by any means," rather than only through capital contributions or debt.  Additionally, the Treasury Decision modified the Anti-Avoidance Rule to be self-executing instead of requiring the District Director to exercise its discretion.

Expansion of the Anti-Avoidance Rule to Cover Partnerships – The Anti-Avoidance Rule did not include transactions where partnerships were controlled by a CFC.  The Temporary Regulations now expand the rule to include situations involving partnerships.  Under the new rule, a CFC will be considered to indirectly hold "United States property" if there is property acquired by a partnership that is controlled by the CFC if such property would be "United States property" if held directly by the CFC and a principal purpose of creating, organizing, or funding by any means the partnership is to avoid the application of Section 956 with respect to the CFC.

New Rule to Cover Certain Foreign Partnership Distributions Funded by CFCs – The Treasury Department and the IRS became aware that CFCs were engaging in transactions in which a CFC would lend money to a foreign partnership and then the foreign partnership would distribute such proceeds from the borrowing to a U.S. partner who is related to the CFC and whose obligation would be "United States property" if the CFC had lent money directly to such U.S. partner.  Alternatively, such a transaction could be structured by having the CFC guarantee a loan made by a third party to the foreign partnership.  The Temporary Regulations now treat an obligation of the foreign partnership as an obligation of the distributee partner (i.e. the related U.S. partner) to the extent that the foreign partnership makes a distribution to the related U.S. partner and the foreign partnership would not have made the distribution but for the funding of the partnership through the obligation.

Summary of the Proposed Regulations

Obligations of Foreign Partnerships Treated as Separate Obligations of the Partners – The Proposed Regulations would generally treat an obligation of a foreign partnership as a separate obligation of each partner in the partnership to the extent of each partner's share of the obligation as determined in accordance with the partner's interest in the partnership profits.  This means that an obligation of a foreign partnership that is held by a CFC would be treated as "United States property" if a partner in the foreign partnership is a U.S. shareholder of a CFC.  Such obligation would be treated as "United States property" to the extent of such U.S. shareholder's share of the obligation as determined in accordance with the partner's interest in the partnership profits.

Certain Foreign Partnership Distributions Funded by CFCs – The Proposed Regulations contain a similar rule to the new rule in the Temporary Regulations discussed above concerning foreign partnership distributions funded by CFCs.  The Treasury Department and the IRS expect to withdraw the rule in the Temporary Regulations when the Proposed Regulations are adopted in final form.

Pledges and Guarantees – The Proposed Regulations address how certain pledges and guarantees of partnerships and partners are analyzed for purposes of Section 956.  First, an obligation of a foreign partnership that is treated as an obligation of a U.S. shareholder under the rule in the Proposed Regulations discussed above would be treated as "United States property" to a CFC if the CFC guarantees such partnership obligation.  Second, a partnership that guarantees an obligation of a U.S. person would be treated as holding such obligation for purposes of Section 956.  Accordingly, if an obligation is of a U.S. shareholder of a CFC and the CFC is a partner in a partnership that provides a guarantee, such obligation would be treated as "United States property" to such CFC in an amount equal to such CFC's share of such obligation.  Third, the amount of an obligation taken into account by a CFC in determining the amount of its "United States property" with respect to a pledge or guarantee is the unpaid principal amount of the obligation to which the pledge or guarantee relates.  As a result, in cases in which there are multiple pledgers or guarantors that are CFCs or partnerships in which a CFC is a partner, the aggregate amount of the "United States property" treated as held by CFCs may exceed the unpaid principal amount of the obligation.  The Treasury Department and the IRS have specifically asked for comments on whether limitations should be adopted to eliminate the potential for having multiple inclusions that exceed the unpaid principal amount of the obligation.