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A New Hybrid Approach for Partnerships in GILTI and Subpart F Regs

Posted on Sep. 2, 2019

Proposed regulations (REG 101828-19) issued in June extend to subpart F the domestic partnership rules of the final regulations (T.D. 9866) that apply to global intangible low-taxed income inclusions.

The proposed GILTI regulations (REG 104390-18) released in October 2018 took a hybrid approach to domestic partnerships that treated them as aggregates or entities depending on the status of their partners. The final GILTI regulations abandon that approach and treat domestic partnerships as aggregates or entities depending on the question being asked.

The proposed regs extend that GILTI treatment to subpart F inclusions. They add a new paragraph (d) to Treas. reg. section 1.958-1 that has three subparagraphs: the general rule, the exception to the general rule, and two examples. The general rule is that a domestic partnership isn’t treated as an entity owning stock of a foreign corporation under section 958(a) for sections 951 (subpart F) and 951A (GILTI), and any other provision that applies by reference. When that rule applies, a domestic partnership is treated in the same manner as a foreign partnership under section 958(a)(2) and reg section 1.958-1(b) to determine the persons that own stock in the corporation. In other words, the general rule is to treat domestic partnerships as aggregates of their partners.

Under the exception in Treas. reg. section 1.958-1(d)(2), the general rule doesn’t apply to determine whether any U.S. person is a U.S. shareholder (as defined in section 951(b)), whether any U.S. shareholder is a controlling domestic shareholder (as defined in reg. section 1.964-1(c)(5)), or whether any foreign corporation is a controlled foreign corporation (as defined in section 957(a)). In other words, when the exception applies, the domestic partnership is treated as an entity.

Background

Section 958(a)(2) provides that stock owned by a foreign corporation, foreign partnership, foreign trust, or foreign estate is treated as owned proportionately by its shareholders, partners, or beneficiaries; it doesn’t address stock owned by domestic entities, including domestic partnerships.

U.S. tax law has historically treated a partnership as either an aggregate of its partners or as an entity separate from its partners, depending on which characterization is more appropriate to fulfill the scope and purpose of the code provision in question.

Since the enactment of subpart F in 1962, domestic partnerships have been treated as entities instead of aggregates for determining whether U.S. shareholders own more than 50 percent of vote or value, and thus whether a foreign corporation is a CFC. That entity characterization has extended to treating a domestic partnership as the U.S. shareholder having the subpart F inclusion. When a domestic partnership is treated as an entity, each partner has a distributive share of the subpart F inclusion, regardless of whether each owns enough vote or value to be a U.S. shareholder.

That entity treatment is consistent with the inclusion of a domestic partnership in the definition of a U.S. person, as well as the legislative history of section 951, which includes domestic partnerships in its definition of a U.S. person and, by extension, a U.S. shareholder of a CFC.

Entity treatment is also consistent with sections 958(b) and 318(a)(3)(a), which treat partnerships as owning stock owned by their partners to determine whether more than 50 percent of a foreign corporation is owned by U.S. shareholders.

In contrast to the subpart F treatment of domestic partnerships as entities, foreign partnerships have generally been treated as aggregates to determine stock ownership under section 958(a). Whether a foreign corporation owned by a foreign partnership is a CFC is determined based on the amount of stock owned by the partnership’s domestic partners. If the foreign corporation is a CFC, partners that are U.S. shareholders have the subpart F inclusion.

Section 951A doesn’t have rules about the GILTI treatment of domestic partnerships and their partners. However, the proposed regulations published last October used a hybrid approach that treated a domestic partnership that’s a U.S. shareholder of a CFC as an entity for some partners and an aggregate for others.

For partners that weren’t U.S. shareholders of a CFC owned by a domestic partnership, the partnership U.S. shareholder calculated a GILTI inclusion, and its partners had a distributive share of the inclusion — that is, an entity approach. For partners that were themselves U.S. shareholders of a CFC owned by a domestic partnership, the partnership was treated in the same manner as a foreign partnership — that is, an aggregate approach. The U.S. shareholders were treated (under section 958(a)) as proportionately owning stock owned by the domestic partnership to determine their GILTI inclusion amounts. Neither the final GILTI regs nor the proposed subpart F regs preserve that treatment.

Rationale

The preamble to the proposed subpart F regs explains why the proposed GILTI regs created the hybrid approach and then abandoned it. Treasury and the IRS rejected a pure entity approach to section 951A in the proposed GILTI regs because treating a domestic partnership as the section 958(a) entity owner of stock in all cases would “create unintended planning opportunities for well-advised taxpayers and traps for the unwary.” The government also rejected a pure aggregate approach because it would be inconsistent with existing entity treatment of domestic partnerships under subpart F.

In response to comments noting the complexity arising from the proposed regs’ hybrid approach, Treasury issued final regulations that treat stock owned by a domestic partnership as owned by its partners for determining a partner’s GILTI inclusion, concluding that an aggregate approach is necessary to ensure that a single GILTI inclusion amount is determined based on each taxpayer’s interest in all its CFCs. The final regulations apply to CFC tax years beginning after December 31, 2017.

The result was calls for an aggregate approach for section 951 too, because there was insufficient policy justification for treating domestic and foreign partnerships differently. The choice of law under which a partnership is organized is irrelevant when determining U.S. shareholder and CFC status. Moreover, entity treatment of domestic partnerships results in each partner having a subpart F inclusion even if a partner isn’t a U.S. shareholder and wouldn’t have a subpart F inclusion if the domestic partnership were foreign.

The government considered extending aggregate treatment to all subpart F determinations, but instead noted that the code contemplates that a domestic partnership can be a U.S. shareholder under section 951(b), including by attribution from its partners. Treating a domestic partnership as an aggregate for determining CFC status ignores the statutory treatment of domestic partnerships as U.S. shareholders.

Finally, neither section 958(a) nor any other provision specifies whether and to what extent a domestic partnership should be an entity or aggregate to determine stock ownership for sections 951 and 951A purposes. Section 958(a) is a limited rule of stock ownership for determining the amount taxable to a U.S. person, while section 958(b) is a broader set of constructive ownership rules for determining whether a corporation is a CFC and a U.S. person is subject to tax under section 951.

The conclusion was that treating a domestic partnership as an aggregate for sections 951 and 951A purposes is appropriate because the partners are the ultimate taxable owners of the CFC, and their inclusions are properly computed at the partnership level regardless of whether the partnership is foreign or domestic. That is reflected in the recently proposed subpart F regs, which provide that a domestic partnership should be treated as an aggregate of its partners in determining stock ownership under section 958(a) for subpart F purposes to be consistent with GILTI.

The result is a hybrid approach for both GILTI and subpart F depending on the determination being made. Generally, a domestic partnership that owns a foreign corporation is treated as an entity to determine whether it and its partners are U.S. shareholders, whether it is a controlling domestic shareholder, and whether the foreign corporation is a CFC. The partnership is treated as an aggregate of its partners to determine whether its partners have inclusions under sections 951 and 951A, and for purposes of any other provision that applies by reference to sections 951 and 951A.

When the proposed subpart F regs are finalized, domestic partnerships will cease to be treated as an entity owning stock of CFCs under section 958(a) for determining a subpart F inclusion amount; instead, their partners will be treated as owning stock. Domestic and foreign partnerships will both be treated as aggregates for that purpose.

Examples

The examples in prop. reg. section 1.958-1(d)(3) illustrate how the stock ownership rules for domestic partnerships apply to (1) determine CFC and U.S. shareholder status; and (2) calculate partner inclusions under sections 951 and 951A. A two-step process first determines whether a corporation is a CFC and its owners are U.S. shareholders, then determines the percentage of stock ownership underlying inclusions under sections 951 and 951A.

Example 1 assumes a U.S. parent corporation (USP) and Individual A, an unrelated U.S. citizen, respectively own 95 percent and 5 percent of PRS, a domestic partnership. PRS wholly owns a foreign corporation (FC) (see Figure 1).

Figure 1. Prop. Reg. Section 1.958-1(d)(3), Example 1

Under the reg. section 1.958-1(d)(2) exception, determining whether PRS, USP, and A (all U.S. persons) are U.S. shareholders and whether FC is a CFC is accomplished without regard to the general rule in reg. section 1.958-1(d)(1) that a domestic partnership is treated in the same manner as a foreign partnership — that is, as an aggregate — so entity treatment applies. PRS owns 100 percent of the voting power and value of FC under section 958(a), so PRS is a U.S. shareholder under section 951(b) and FC is a CFC under section 957(a).

USP is a U.S. shareholder of FC because it owns 95 percent of FC’s vote and value under sections 958(b) and 318(a)(2)(A). A, however, isn’t a U.S. shareholder because A owns only 5 percent of FC’s vote and value.

In the second step, the general rule in reg. section 1.958-1(d)(1) applies. Sections 951 and 951A do not treat PRS as an entity owning the FC stock, and instead treat it in the same manner as a foreign partnership (as an aggregate). USP is treated as owning 95 percent of the FC stock, and A is treated as owning 5 percent of the FC stock. USP is a U.S. shareholder of FC and determines its income inclusions under subpart F and GILTI based on its ownership. A doesn’t have income inclusions under section 951 or GILTI.

In Example 2, USP and A respectively own 90 percent and 10 percent of PRS1, a U.S. partnership. PRS1 and Individual B, a nonresident alien, respectively own 90 percent and 10 percent of PRS2, also a domestic partnership. PRS2 owns 100 percent of FC’s stock. USP, A, and B aren’t related (see Figure 2).

Figure 2. Prop. Reg. Section 1.958-1(d)(3), Example 2

As in Example 1, the prop. reg. section 1.958-1(d)(2) exception treats PRS2 as an entity, causing PRS2 to be a U.S. shareholder and FC to be a CFC. PRS1 is treated as owning 100 percent of FC’s stock for determining the stock to be treated as owned by USP and A. USP is treated as owning 90 percent of FC’s stock (100% PRS2 * 100% PRS1 * 90% USP), and A is treated as owning 10 percent under the same formula (100% PRS2 * 100% PRS1 * 10% A). Unlike Example 1, both USP and A are U.S. shareholders of FC under section 951(b).

Under the general rule, PRS1 and PRS2 aren’t treated as entities owning FC stock, but are treated in the same manner as foreign partnerships for determining the stock owned by USP and A.

To determine the amounts included in gross income under sections 951 and 951A, USP is treated as owning 81 percent (100% * 90% * 90%), and A is treated as owning 9 percent (100% * 90% * 10%). Because USP and A are both U.S. shareholders of FC, they determine their inclusions under sections 951 and 951A based on their ownership of FC stock under section 958(a) (see the table). The remaining 10 percent of FC’s stock will not generate subpart F or GILTI inclusions because it is owned by B, who isn’t a U.S. person.

Domestic Partnership Owns Stock in Foreign Corporation

Method 

Entity

Aggregate

Determination 

CFC and U.S. Shareholder Status

GILTI and Subpart F Inclusions

USP

90%

81%

A

10%

9%

Notice 2019-46

In Notice 2019-46, 2019-37 IRB 1, the IRS announced that it intends to issue regulations that allow a domestic partnership (or S corporation) to apply the proposed GILTI regulations for tax years ending before June 22, 2019 (the day after the final GILTI regs were published). Because many domestic partnerships furnished Schedules K-1 to their partners on or before June 21, the schedules may have reported a partner’s distributive share of a domestic partnership’s GILTI inclusion amount, which is no longer appropriate under the final regulations.

Absent relief, those domestic partnerships would be required to apply the final regs in filing their 2018 returns, which would require issuing Schedules K-1 consistent with the return’s Schedule K. Issuing corrected Schedules K-1 will create costs for partnerships and processing burdens for the IRS. Accordingly, Treasury and the IRS are allowing partnerships to apply the rules in the proposed regs for tax years ending before the date the final regs were published (December 31, 2018, for calendar year taxpayers).

The future regs will also provide that future distributions by a partnership, CFC of a partnership, or S corporation are excluded from the partners’ gross income under section 959 only if previously included in income under prop. reg. section 1.951-5.

If a domestic partnership issues Schedules K-1 using the proposed regulations but files a tax return consistent with the final regs under reg. section1.951A-1(e), the partnership can avoid penalties by satisfying partner notification and IRS reporting requirements.

Two examples in section 6 of Notice 2019-46 illustrate the expected guidance. In both examples, domestic corporation USP and U.S. citizen Individual A respectively own 95 and 5 percent of PRS, a domestic partnership. PRS wholly owns CFC1 and USP wholly owns CFC2. All parties have a calendar tax year.

In 2018 CFC1 had tested income of $100 and CFC2 had a tested loss of $45. In 2019 CFC1 earns no income and distributes $100 from earnings and profits to PRS (see Figure 3).

Figure 3. Notice 2019-46, Examples 1 and 2

In Example 1, based on the recently issued proposed regulations, PRS provided Schedules K-1 that indicated a pro rata share of tested income of $95 to USP and a distributive share of a GILTI inclusion of $5 to A. Under either the proposed or final regulations, USP’s 2018 GILTI inclusion is $50 (its $95 share of CFC1’s tested income minus its $45 share of CFC2’s tested loss). A included its $5 distributive share of CFC1’s GILTI based on Schedule K-1 received from PRS. PRS intends to file its 2018 Form 1065 on September 16 and would like to apply the proposed regs.

PRS must provide notifications to USP and A that their 2018 Schedules K-1 are consistent with the proposed regs and that it is filing its 2018 Form 1065 under the proposed regs. PRS must also attach a similar notification to its Form 1065.

PRS must separately state on the 2019 Schedules K-1 the partners’ distributive shares of CFC1’s $100 distribution, which is $95 for USP and $5 for A. USP included $50 in GILTI income in 2018, so only $45 of the $95 is included in USP’s income (before the application of section 245A). A included $5 of its distributive share of PRS’s GILTI inclusion in 2018, so none of the $5 distribution is included in A’s income in 2019.

The facts are the same in Example 2, except that PRS intends to file its 2018 Form 1065 applying the final regulations. As in Example 1, USP must notify USP and A that their 2018 Schedules K-1 use the proposed regs, while the 2018 Form 1065 uses the final regs. Again, PRS must attach a similar notification to its Form 1065.

The 2019 Schedules K-1 report the $100 distribution as in Example 1, with the same income inclusion results. If the final regulations had been applied to the Schedules K-1 in 2018, A wouldn’t have had a $5 GILTI inclusion in 2018. Instead, A would have $5 in income in 2019 from the E&P distribution.

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