Foreign and Tax-Exempt Partners' Tax Years

Treasury issued Sec. 706 final regulations (TD 9009) on the tax year of a partnership with foreign and tax-exempt partners. Under the regulations, a partnership's tax year will be determined without regard to the tax year of its foreign and tax-exempt partners, under certain circumstances. The regulations also provide relief for certain foreign partnerships in existence, and transitional rules for those who elect to conform to the new rules.

Permissible Tax Years

Under Sec. 706(a), in computing a partner's taxable income for a tax year, the partner must include its share of any partnership income, gain, loss, deduction or credit for the partnership's tax year that ends within or with the partner's tax year.

According to Sec. 706(b)(1)(B), unless a partnership establishes a business purpose for a different tax year, it cannot have a tax year other than (1) the majority-interest tax year; (2) if no majority-interest tax year exists, the tax year of all principal partners; or (3) if no tax year is described in (1) or (2), the calendar year, unless regulations prescribe another period. Under Regs. Sec. 1.706-1(b)(2), if neither Sec. 706(b)(1)(B)(i) nor (ii) apply, the partnership's tax year will be the tax year that results in the least aggregate deferral of partnership income.

For tax-exempt partners, the 1988 proposed regulations have been finalized without substantive change. The proposed and final regulations provide that in determining a partnership's current tax year, a tax-exempt partner under Sec. 501(a) would be disregarded if such partner were not subject to tax on any income attributable to its investment in the partnership during the partnership's tax year immediately preceding the current year.

The regulation's apparent purpose is to prevent taxable partners from obtaining a deferral not otherwise available without adverse consequences to tax-exempt partners.

The treatment of foreign partners was addressed in 2001 proposed regulations, which generally provided that a foreign partner not subject to U.S. taxation on a net basis on partnership earned income is disregarded for Sec. 706(b) purposes. A foreign partner will be deemed subject to U.S. taxation on a net basis, only if it is allocated partnership gross income that is U.S. effectively connected income (ECI) (i.e., effectively connected with a U.S. trade or business). A foreign partner claiming benefits under a U.S. income tax treaty is disregarded, unless it is allocated any gross income attributable to a permanent establishment in the U.S.

The final regulations follow this same approach. However, they clarify the general rule that a foreign partner is disregarded unless it is allocated any gross income that is ECI, and the taxation of the income is not otherwise precluded under any U.S. income tax treaty. Further, the IRS may challenge an arrangement that, while conforming to the rules, is undertaken with a principal purpose of achieving a tax result inconsistent with Sec. 706's intent.

Minority Partners

Treasury and the Service recognized that, in some cases, determining a partnership's tax without regard to certain foreign partners presents difficulties for minority partners. For this reason, the proposed regulations included a minority-interest rule, which provides that foreign partners' tax years will not be disregarded for Sec. 706(b) purposes, if (1) no single partner holds a 10%-or-greater capital or profits interest in the partnership and (2) in the aggregate, foreign partners not disregarded do not hold a 20%-or-greater partnership interest. Secs. 267(b) and 707(b) attribution rules apply in this context.

Despite comment on the low 10% and 20% thresholds, the final regulations adopted the language of the 2001 proposed regulation. However, in an attempt to acknowledge this concern for existing partnerships, the final regulations apply mandatorily only to partnerships formed after Sept. 23, 2002. Partnerships formed before that date can elect to change their partnership year to conform to the final regulations.

Transition Rule

Because the final regulations do not require existing partnerships to change their tax years, the need for transitional relief is less important. Nevertheless, to encourage existing partnerships to change their tax years to conform to the final regulations, Treasury and the IRS have retained the Temp. Regs. Sec. 1.702-3T transitional rule, for any partnership that elects to apply the regulations in its first tax year beginning after July 22, 2002. A partnership that uses the transitional rule must take into account all items of income, gain, loss, deduction and credit ratably over a four-year period.

Conclusion

The final regulations retained a major portion of the 1988 and 2001 proposed regulations on the tax year of foreign and tax-exempt partners, and added clarity. However, because Treasury received comments on the proposed regulations, relief is now available for certain partnerships in existence on Sept. 23, 2002, with minority partners adversely affected by the final rules. Partnerships who wish to conform also get transitional relief in the form of a four-year spread on income "bunched up" by these rules.

The final regulations' effective date applies to tax years beginning after July 22, 2002, except as otherwise noted.

From Antonio D. Pimenta, CPA, PKF, New York, NY