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Transfer of intangible assets by partners to partnerships intended to shift pre-contribution gain to foreign partners

Transfer of intangible assets by partners

The IRS publicly released a field advice memorandum* (the “memo”) concluding that the contribution by U.S. partners of contributed intangible assets to the partnership—and the use of the traditional method with only limited back-end curative allocations to account for the built-in gain under section 704(c)—was made with a view to shifting the tax consequences of the pre-contribution gain in the assets from the U.S. partners to a foreign partner in a manner that substantially reduced the present value of the partners’ aggregate federal tax liability.

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Read 20204201F [PDF 297 KB] (released October 16, 2020, and dated April 22, 2020).

The memo (which is redacted) concludes that the elements of the section 704(c) anti-abuse rule were met, and that the IRS could exercise its authority to place the partnership on the curative method with respect to the contributed intangible assets and allocate sufficient tax items to eliminate the effect of the ceiling rule distortion for the tax year at issue.

*The memoranda prepared by field attorneys in the Office of Chief Counsel are reviewed by an Associate Office, and subsequently issued to field or service center campus employees of the Internal Revenue Service.

Summary

The memo responded to a request about contributions by a U.S. taxpayer (“taxpayer”) and its subsidiary (a member of the taxpayer’s U.S. consolidated group) of high-value, low-basis intangible property to a disregarded entity owned by a foreign affiliate of the taxpayer. The disregarded entity previously owned high-value, high-basis property and became a partnership for U.S. federal income tax purposes as a result of the contributions. The partnership elected the traditional method with a limited back-end curative gain-on-sale allocation for purposes of applying section 704(c).

At issue was whether the contributions and choice of the section 704(c) method were made “with a view” to shifting the tax consequences of the pre-contribution gain from the taxpayer and its subsidiary to the foreign affiliate in a manner that substantially reduced the present value of the partners’ aggregate federal tax liability, as described in the anti-abuse rule of Reg. section 1.704-3(a)(10)(i).

In analyzing whether the taxpayer’s section 704(c) method for the contributed intangible assets shifted the tax consequence of the contributed property’s built-in gain, the memo notes that because the those assets were contributed with zero basis and because section 704(b) amortization was allocated in accordance with the partners’ sharing percentages, the foreign partner would be prevented from receiving tax amortization to match its section 704(b) amortization, thereby causing the effect of the contributed intangible assets’ built-in-gain to shift from the U.S. partners to the foreign partner. 

The memo explains that the partnership agreement’s curative provision is triggered only upon a taxable disposition; that the partnership controlled any decision to make such a disposition; and that it would be unlikely to make such a decision given its tax cost.  Further, the memo notes the taxpayer represented that upon the partnership’s formation, there was no intention to sell the contributed intangible assets, and that none had in fact been sold.  Finally, the memo observes that even if a sale occurred at the remaining fair market value, it would result in only a de minimis gain allocation, given the forecasted decline in the fair market value of the contributed intangible assets and the fact that the provision restricted items from which curative allocations could be made to items of tax gain on sale of those assets and not simply any available items. 

The memo also concludes that the shift in the consequence of the built-in-gain resulted in a substantial reduction in the present value of the partners’ aggregate federal tax liability because the foreign partner was not subject to U.S. federal income tax and the partnership’s income was not U.S.-source income, whereas the U.S. partners were subject to a tax rate of up to 35%. Further, the amount of income shifted from the U.S. partners to the foreign partner was substantial. 

Having concluded that the section 704(c) method chosen shifted the consequence of the built-in-gain and resulted in a substantial reduction in the present value of the partners’ aggregate federal tax liability, the IRS interpreted the requirement that the use of a section 704(c) method be made “with a view” to shifting such tax consequences.  The IRS reasoned that the “with a view” standard presents a lower threshold than other anti-abuse rules, such as the general partnership anti-abuse rule, which requires a showing that a partnership was formed or availed of in connection with a transaction “a principal purpose of which” is to reduce the partners’ aggregate tax liability. Reg. section 1.701-2(b).  Instead, the IRS looked to regulations and other guidance interpreting the “with a view” standard, concluding that it merely requires “that the proposed actions be ‘contemplated’ by the taxpayer or a ‘recognized possibility’ because absent a robust anti-abuse rule, taxpayers could manipulate…§704(c) methods (in the current case), to produce unwarranted tax benefits.”

Applying this standard to the taxpayer, the IRS noted that the partners are all related, know the tax attributes of the other partners, and therefore were in a position to understand and exploit the tax saving effects of the various section 704(c) methods. Further, the parties chose the method that maximized the shift of built-in gain to the foreign affiliate (a tax-indifferent party), controlled the timing of any sale (and thus, curative allocations), and were aware that any sale of the contributed intangibles was unlikely to generate curative items sufficient to fully offset the full amount of prior year shifts caused by the ceiling rule. 

Finally, the IRS looked to the taxpayer’s use of sophisticated outside advisors and the taxpayer’s lack of provision in its financial statements evidencing that the taxpayer had the view that the built-in gain from the contributed intangible assets would never be subject to U.S. tax to conclude that the method was adopted “with a view” to shift the tax consequence of the built-in-gain from those assets.  The memo further states that the taxpayer’s business purpose of cost and resource efficiencies are irrelevant in determining whether the section 704(c) method was adopted with a view to shift the tax consequence, even if its business purpose was the primary motive. 

The memo concludes that the requirements of the anti-abuse rule were met, and the IRS exercised its authority to put the partnership on the curative method which would require the partnership to allocate items to cure the ceiling rule distortion.  

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