Firm Troubled by Some Aspects of Proposed UBTI Regs

June 23, 2020

CC:PA:LPD:PR (REG-106864-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Comments on Proposed Regulations under Section 512(a)(6)

Dear Sir or Madam,

We are submitting the attached comments with respect to the Notice of Proposed Rulemaking, REG-106864-18, implementing Section 512(a)(6), on behalf of several clients. Please do not hesitate to be in touch if you would like to discuss the comments or if you have any questions.

Respectfully submitted,

Kendi E. Ozmon

Brittany G. Cvetanovich

Ropes & Gray LLP
Boston, MA

Attachment

Cc:
Roger Pillow, Department of Treasury
Bryan Rimmke, Department of Treasury

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Comments on the Section 512(a)(6) Proposed Regulations

A. Request for ability to opt out of treatment of debt-financed income and loss as part of investment activities

The April 24, 2020 Notice of Proposed Rulemaking implementing Section 512(a)(6) (the “NPRM” or “Proposed Regulations”) provides that debt-financed unrelated business taxable income (“UBTI”) (including debt-financed UBTI from partnership investments) is part of an exempt organization's investment activities, including where such debt-financed UBTI is generated from a partnership investment that is not eligible for treatment as a qualifying partnership interest (“QPI”). We appreciate the IRS and Treasury's recognition that debt-financed UBTI should be included in the investment activities silo. However, to the extent a partnership does not qualify for QPI status, such an approach could place additional administrative burdens on partnerships and exempt organizations and artificially inflate an organization's net UBTI from a partnership investment, because it would require the partnership and the exempt organization to separate debt-financed UBTI from other UBTI generated by the partnership.

To address these concerns, we request that in the event a partnership interest is not treated as a QPI, an exempt organization be permitted to make a one-time election to opt out of treating debt-financed UBTI income, gain and loss from such non-QPI as part of its UBTI from investment activities. Instead, the organization would be permitted to group such income, gain and loss by NAICS 2-digit sector code based on the underlying trade or business of the partnership. The election would be made on a partnership-by-partnership basis and, if made, would be required to be made on the exempt organization's Form 990-T for the first taxable year during which the final regulations are effective and the exempt organization has debt-financed UBTI income, gain or loss from such partnership. Once made, the election could not be changed, absent unintentional error, unless the partnership interest changes from non-QPI status to QPI status.

B. Request to permit interests in controlled foreign corporations (“CFCs”) to be aggregated with investment activities

We would propose to replace the rule of the Proposed Regulations that all Subpart F insurance income is its own separate silo with a rule that would permit interests in CFCs to be aggregated with investment activities if such interests would be eligible for treatment as a QPI if the interest were a partnership interest.

We believe the separate silo rule of the Proposed Regulations is based on the incorrect conclusion that an organization must have significant control over a CFC to realize Subpart F income. Specifically, the NPRM noted that “like section 512(b)(13), the required degree of control of the exempt organization over the controlled foreign corporation indicates that the exempt organization's interest in a controlled foreign corporation probably is not a part of the exempt organization's otherwise appropriately characterized investment activities. In particular, section 951(a)(1)(A) applies only if a foreign corporation is a controlled foreign corporation, which section 957 defines as any foreign corporation if more than 50 percent of the total combined voting power of all classes of stock of such corporation entitled to vote or the total value of the stock of such corporation is owned, directly, indirectly, or constructively by United States shareholders.”

The statement in the NPRM that a corporation must be 50% owned or controlled by United States Shareholders in order to be a CFC is incorrect. Although this is the general rule for CFC status, the required ownership by United States Shareholders is reduced to 25% for insurance income specifically.¹ An organization is a United States Shareholder of a CFC if it owns 10% by vote or value, including by application of certain constructive ownership rules.² Thus, an exempt organization could actually hold less than a 10% interest in a CFC that, as a whole, is only 25% owned by United States Shareholders and still have Subpart F insurance income. Accordingly, we request that an interest in a CFC be eligible for treatment as an investment activity if the interest would be eligible for treatment as a QPI if it were an interest in a partnership.

C. Request to remove Type III supporting organizations from the group of organizations whose interests exempt organizations must aggregate with their own holdings for purposes of the control test

The Proposed Regulations require an exempt organization to aggregate its ownership interests in partnerships with those of Section 512(b)(13) controlled entities, and all supporting organizations, when determining whether the organization holds a no more than 20% interest in a partnership for purposes of the control test set forth in Section 1.512(a)-6(c)(4) of the Proposed Regulations.

It is burdensome and impractical for an organization to aggregate its interests with those held by its Type III supporting organizations given that, by definition, the organization does not control or necessarily have a right to access the financial information of Type III supporting organizations. A wide variety of organizations may be categorized as Type III supporting organizations, and a supported organization may have little influence, either as a legal or practical matter, over a Type III supporting organization. It would be highly challenging, at the least, for exempt organizations to obtain this information from their Type III supporting organizations. Further, there is nothing in the statute compelling attribution from Type III supporting organizations for this purpose.

We therefore request that an exempt organization not be required to take into account partnership interests held by Type III supporting organizations in determining its interest in a partnership for purposes of determining whether the interest is a QPI.

D. Requests with respect to net losses

The Proposed Regulations require exempt organizations to use net losses from unrelated trade or business activities generated during taxable years beginning prior to the effective date of Section 512(a)(6) (“pre-2018 losses) before any such losses incurred in taxable years to which Section 512(a)(6) applies (“post-2017 losses”), so as to maximize the usage of pre-2018 losses before they expire. We believe each exempt organization should be permitted to order its use of losses based on its own facts and circumstances. We therefore request that exempt organizations be permitted to choose whether to use pre-2018 losses or post-2017 losses in a given taxable year.

Furthermore, the final regulations should make clear that organizations are permitted to use post-2017 losses incurred in a particular trade or business if they suspend and later resume that trade or business. For example, if in a particular year an organization has no activity classified by a particular NAICS 2-digit code, it should be able to use any losses classified as derived from activities falling under that particular NAICS 2-digit code if it ever again has such activities in the future. The Proposed Regulations do not address this issue, creating uncertainty as to whether exempt organizations would be permitted to use prior losses in this situation.

E. Request for extension of effective date of final regulations

The NPRM proposes that the Proposed Regulations are to apply to taxable years beginning on or after the date these regulations are published in the Federal Register as final regulations. For taxable years beginning before the date such regulations are published in the Federal Register as final regulations, an exempt organization may rely on a reasonable, good-faith interpretation of sections 511 through 514, considering all the facts and circumstances, when identifying separate unrelated trades or businesses for purposes of section 512(a)(6). In addition, for these same taxable years, an exempt organization may rely on the Proposed Regulations in their entirety. Alternatively, for these same taxable years, an exempt organization may rely on the methods of aggregating or identifying separate trades or businesses provided in Notice 2018-67.³

We request that the final regulations apply to taxable years beginning on or after the first day of the calendar year beginning after publication of final regulations in the Federal Register. Otherwise, the effective date rule included in the Proposed Regulations could result in the final regulations applying to taxable years beginning within the calendar year such regulations are issued. This could result in the final regulations essentially applying retroactively to many exempt organizations' partnership investments.

For example, if final regulations are issued in June 2021 and the effective date rule in the Proposed Regulations is adopted, for an exempt organization with a June 30 taxable year (such as many colleges and universities), such final regulations would apply to taxable years beginning on July 1, 2021. Like all partners, tax-exempt partners are required to include their share of income generated by a partnership in which they invest in their income for the taxable year in or with which the taxable year of the partnership ends. The organization would thus include in its income for the taxable year beginning July 1, 2021 income generated by a calendar year partnership during calendar year 2021. As a result, for an organization with a June 30 taxable year, if final regulations are published after January 1 but prior to June 30 of a particular year, with the effective date principle of the Proposed Regulations, such final regulations would apply to Schedules K-1 that cover periods beginning prior to issuance of the final regulations.

We request an extension of the effective date to give exempt organizations and partnerships with tax-exempt investors the chance to adapt their policies and procedures to ensure compliance with the requirements of the final regulations. Given the extensive and complex nature of many exempt organizations' investment activities, and the administrative burdens involved in calculating UBTI from various activities and preparing Forms 990-T, we believe a delayed effective date for the final regulations is necessary to ensure that exempt organizations have the time they need to implement the final regulations properly and that partnerships in which they invest have sufficient time to provide exempt organization with the information necessary for compliance. We propose that, for taxable years not subject to the final regulations, an exempt organization be permitted to continue to rely on any transition relief provided in the Proposed Regulations and that for such years an organization be permitted to apply (1) a reasonable, good-faith interpretation of Sections 511 through 514, considering all the facts and circumstances, (2) the final regulations, (3) the Proposed Regulations, or (4) the methods of aggregating or identifying separate trades or businesses provided in Notice 2018-67.