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Notre Dame Suggests Rule for UBTI From Investment Partnerships

NOV. 29, 2018

Notre Dame Suggests Rule for UBTI From Investment Partnerships

DATED NOV. 29, 2018
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November 29, 2018

The Honorable David Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220

Ms. Stephanie N. Robbins
Office of Associate Chief Counsel (TEGE)
Internal Revenue Service
1111 Constitution Ave., NW
Washington, DC 20224

The Honorable Charles Rettig
Commissioner
Internal Revenue Service
1111 Constitution Ave., NW
Washington, DC 20224

Mr. Jonathan A. Carter
Office of Associate Chief Counsel (TEGE)
Internal Revenue Service
1111 Constitution Ave., NW
Washington, DC 20224

Re: Response to Request for Comments in Notice 2018-67, Calculating Unrelated Business Taxable Income under § 512(a)(6)

Dear Sirs and Madam:

I. Introduction

Pursuant to Notice 2018-67 and the request for comments therein, the University of Notre Dame du Lac respectfully submits these comments with respect to the application of Section 512(c)(6) of the Code to unrelated business taxable income (“UBTI”) generated from investments in partnerships.

We are a large private university that is tax-exempt under Section 501(c)(3) of the Code. We maintain an endowment fund that is used to support the University's operations and to provide financial aid to our students. A portion of the endowment fund is invested in private investment funds, which are typically structured as limited partnerships or other entities that are classified as partnerships for U.S. federal income tax purposes (“Investment Funds”). At any time, these Investment Funds number in the hundreds.

The Investment Funds may generate UBTI as a result of investing in businesses that are themselves structured as a pass-through entities (“Lower Tier Partnerships”), have an underlying nature that creates UBTI, or possibly as a result of borrowing by the Investment Funds or the Lower Tier Partnerships, or from certain fees earned by the Investment Funds in connection with their investment activities.

As limited partners in the Investment Funds, we are a passive investor and do not significantly participate in the management of the Investment Funds, their investment decisions or their other operations. Investment decisions are made by each Investment Fund's general partner, and in some cases by an investment manager that is typically affiliated with the general partner. We generally do not have any interest in the general partner or the investment manager. In some cases we may be part of an advisory committee made up of limited partners, which has limited authority to approve certain transactions that are outside of the scope of an Investment Fund's normal investment parameters or that involve a conflict of interest for the Investment Fund's general partner.

Our percentage interest in the Investment Funds in which we invest varies, but typically we do not hold greater than a 2% interest. Less than 10% of the time we may exceed a 20% interest in an Investment Fund. We rarely hold a greater than 50% interest in an Investment Fund. Because of our minority ownership status, we would have little leverage related to investment and operational decisions of each partnership.

II. Section 512(a)(6) and Notice 2018-67

For tax years beginning after December 31, 2017, newly enacted Section 512(a)(6) of the Code requires exempt organizations, such as us, to compute UBTI separately with respect to each unrelated trade or business. Due to the number of Investment Funds in which we hold interests, and the number of Lower Tier Partnerships in which the Investment Funds hold interests, it would be administratively burdensome for us to determine our UBTI separately with respect to each Investment Fund and/or each Lower Tier Partnership. In most cases, we do not currently receive or have access to the information that would be necessary for us to make such a determination. The Treasury Department and the IRS noted the potential difficulty we, and similarly situated investors, would face in obtaining the necessary information to report UBTI for each Investment Fund/Lower Tier Partnership.

Section 5.02 of Notice 2018-67 indicates that, as a matter of administrative convenience and to reduce the burden on both exempt organizations and the IRS, the Treasury Department and the IRS intend to propose regulations treating certain activities in the nature of an investment as one trade or business. Notice 2018-67 goes on to say that investments in partnerships could be included as investment activities where the exempt organization does not significantly participate in any partnership trade or business.

Section 6 of Notice 2018-67 contains interim rules that permit exempt organizations to aggregate UBTI from an investment in a single partnership with multiple trades or businesses, and to aggregate UBTI from investments in multiple partnerships, in each case if the partnerships meet either a “de minimis test” or a “control test.” The de minimis test is met if the exempt organization holds no more than 2% of the profits interest and no more than 2% of the capital interest in the partnership, The control test requires an exempt organization to hold no more than 20% of the capital interest in the partnership and not to have control or influence over the partnership. For purposes of both the de minimis test and the control test, an exempt organization's percentage interest in a partnership includes interests held by a “disqualified person” (within the meaning of Section 4958(f) of the Code), a “supporting organization” (within the meaning of Section 509(a)(3) of the Code), or a “controlled entity” (within the meaning of Section 512(b)(13)(D) of the Code). Section 6.04 of Notice 2018-67 contains a transition rule that permits exempt organizations to treat all UBTI from a partnership interest acquired prior to August 21, 2018 as a single trade or business (but does not permit such partnership interest to be aggregated with other partnerships).

III. Recommendation 1: Income Generated From Investment Partnerships Should be Treated as an Investment Activity that Constitutes One Trade or Business

We agree with the Treasury Department's and the IRS' proposal to treat activities in the nature of an investment as one trade or business. As suggested in Notice 2018-67, we believe that investments in partnerships in which the exempt organization does not significantly participate should be treated as an investment activity that constitutes a single trade or business. Therefore, we recommend that the Treasury Department and the IRS adopt a rule that treats all investments by an exempt organization in investment partnerships as one trade or business, so long as the exempt organization does not have any interest in the general partner or the investment manager.

The Investment Funds in which we invest are generally structured as limited partnerships in which we are a limited partner. The nature of a limited partnership interest (as opposed to a general partnership interest) limits the limited partner from significantly participating in the investment activities or operations of the partnership. The general partner, and in some cases an investment manager, are responsible for making all investment decisions and managing the Investment Fund, for which they are paid management fees. As a limited partner, our voting rights are limited to extraordinary actions such as approving significant amendments to the partnership agreement, removing the general partner, and terminating or extending the term of the Investment Fund. These voting rights are similar to the voting rights that an investor in corporate stock would have. In some cases we and other limited partners may serve on an advisory committee whose role is generally limited to approving certain conflict of interest transactions involving the general partner, and approving actions that fall outside of the scope of investment guidelines set out in the partnership agreement. These limited approval rights do not constitute significant participation in the operations or investments of the Investment Funds. Our interest in the Investment Funds is truly that of a passive investor.

Furthermore, as is common for other tax-exempt universities, our investment activity (including investments in Investment Funds) is managed separately from and by a different department than other activities that may generate UBTI and without consideration being given to any such other activities, and thus it is appropriate to treat any UBTI generated from Investment Funds as resulting from a separate investment activity and a single trade or business.

Finally, treating all investment partnerships as a single trade or business, regardless of the percentage ownership held by the exempt organization, would achieve the Treasury Department's and IRS' stated goal of easing the administrative burden on exempt organizations and the IRS. Our percentage interest in any Investment Fund may change from year-to-year based on the coming and going of other investors in the Investment Fund, changes in the amount we have invested in the Investment Fund, and changes in our share of the profits and losses generated by the Investment Fund as certain performance hurdles are met. If our ability to aggregate our UBTI from Investment Funds were dependent on our falling below a certain percentage interest threshold of the type applied for purposes of satisfying the de minimis test and the control test as set forth in Notice 2018-67, Investment Funds that would meet those tests may change on a yearly basis, making compliance very difficult with respect to an Investment Fund that is aggregated in one year but that cannot be aggregated in another year. For example, would losses generated by an Investment Fund in a year in which such Investment Fund was aggregated with other Investment Funds (but not fully used to offset income from those other Investment Funds) be available to offset income from that same Investment Fund in a year in which the Investment Fund is not aggregated with other Investment Funds? Furthermore, in practice we may not know our exact percentage interest in a particular Investment Fund because the Schedule K-1 that we are provided by Investment Funds sometimes does not specify our percentage interest. Notice 2018-67 provides that we cannot satisfy the minimis test (and is unclear as to whether we are able to satisfy the control test) if our percentage interest is not specified on our Schedule K-1, even though we must rely on the general partner to provide that information. If this first recommendation is adopted, our other recommendations in this letter would not be necessary. However, if our first recommendation is not adopted we appreciate your consideration of our other recommendations.

IV. Recommendation 2: The Control Test Should be Based on Holding No More than 50% of Profits or Capital

If the Treasury Department and IRS do not adopt our first recommendation to treat UBTI from all investment partnerships as a single investment activity, an expanded version of the control test should be adopted. We support the general approach of Notice 2018-67 to create rules under which the UBTI derived from investments in partnerships can be aggregated as constituting a single investment activity. While it is inherent in the legal nature of a limited partnership (as opposed to a general partnership) that limited partners do not participate in day-to-day management of the partnership and it is therefore arguable that no limited partner can ever control a limited partnership, we understand the concept of a control test. However, the control test should be changed to an objective test that is satisfied if the exempt organization holds no more than 50% of the profits or capital interest in the partnership.

To achieve the Treasury Department and IRS' stated goals of reducing the reporting and administrative burden on exempt organizations and reducing the burden on the IRS, the control test should be an objective test that can be more efficiently applied by exempt organizations and the IRS. The control test as set forth in Notice 2018-67 does not achieve this goal because it includes a “control or influence” standard that is determined based on all facts and circumstances of a particular partnership interest. Applying a facts and circumstances test to each of the Investment Funds in which we currently have a greater than 2% interest would create a significant compliance burden both for us and for the IRS. As a practical matter, the Investment Funds in which we invest are typically limited partnerships, and as a limited partner we do not significantly participate in any trade or business of the Investment Funds or the Lower Tier Partnerships. However, “influence and control” is a concept that is not used in other areas of tax law so there is no developed authority as to what “influence and control” means. Further, as explained in Section 3 of Notice 2018-67, the Treasury Department and the IRS explicitly rejected the use of a facts and circumstances test for identifying separate trades of businesses for the purposes of Section 512(a)(6) of the Code because it would increase the administrative burden on exempt organizations and the IRS. Use of a facts and circumstances test for determining control or influence would pose equally significant administrative burdens and therefore should not be incorporated in any final rule for the application of Section 512(a)(6) of the Code.

The control test should be based on an objectively measurable percentage ownership threshold. However, we believe the 20% ownership threshold currently set forth in Notice 2018-67 is too low for purposes of a test for control. A 20% ownership threshold is also inconsistent with the threshold for control as applied to partnerships elsewhere in the Code. In other areas of the Code, control of a partnership is more often defined as owning more than 50% of the profits or capital interest in the partnership. We suggest the same approach should be taken for purposes of adopting a control test under Section 512(a)(6) of the Code. In other words, an exempt organization should be allowed to aggregate its UBTI from any partnership in which it does not hold more than 50% of the capital or profits interests. The use of a 50% threshold would be consistent with other provisions of the Code and would achieve the Treasury Department's and IRS' goal of easing the administrative burden on exempt organizations and the IRS.

Application of a 50% ownership threshold to test for control of a partnership would be objective, easy to administer, and consistent with how control of a partnership is commonly defined elsewhere in the Code. For example, for purposes of imputing UBTI from a “controlled entity” under Section 512(b)(13) of the Code, a partnership is considered a “controlled entity” if the exempt organization owns more than 50% of the profits interests or capital interests of the partnership.1 Similarly, the rules on excess benefit transactions under Section 4958 of the Code treat a partnership as being controlled by an exempt organization if the exempt organization owns more than 50% of the profits interests or capital interests in the partnership.1 Several other sections of the Code similarly apply a 50% ownership threshold when testing for control of a partnership.2 Several other sections of the Code similarly apply a 50% ownership threshold when testing for control of a partnership.3

Adopting an objective 50% control test for purposes of allowing exempt organizations like us to aggregate UBTI from our investments in partnerships that we do not control will greatly reduce the burden that would be imposed if we were required to treat each such partnership (and their underlying businesses) as separate trades or businesses, or were required to apply a facts and circumstances test for control of influence over each such partnership. Thus adopting an objective 50% control test would meet the stated goal of the Treasury Department and the IRS of reducing administrative burden both on exempt organizations and the IRS, as stated in Notice 2018-67.

V. Recommendation 3: The Requirement to Combine Related Interests Should be Limited to Interests Held by Controlled Entities

While in some cases it may be appropriate to aggregate the partnership interests owned by related entities for purposes of determining an exempt organization's ownership percentage, the rules for combining related interests as set forth in Notice 2018-67 are unworkable for large universities and similar exempt organizations. We do not have knowledge of the personal investments made by the members of our Board of Trustees, our officers, our employees, our major donors or our key employees. Furthermore, we do not act in concert with any of the foregoing individuals when investing in Investment Funds. If we are required to combine our partnership interests with those that may be held by persons we do not control and whose investments are unknown to us, we could never be certain whether we have met the 50% control test.

To achieve the Treasury Department and IRS' stated goals of reducing the reporting and administrative burden on exempt organizations and reducing the burden on the IRS, an exempt organization must be able to readily determine whether it has met the control test with respect to an investment in a partnership. To this end, an exempt organization should only be required to combine its partnership interests with interests held by entities that the exempt organization controls. An exempt organization should not be required to combine its partnership interests with interests held by persons or organizations which are not controlled by the exempt organization. Requiring an exempt organization to combine its partnership interests with those owned by a controlled entity achieves the goal of preventing an exempt organization from manipulating its ownership percentage by spreading its ownership among various controlled entities. However, it is not necessary, and as previously noted, it would not be feasible, to require the exempt organization to aggregate its partnership interests with those held by persons and organizations which the exempt organization does not control and whose investments it cannot monitor.

VI. Recommendation 4: The Transition Rule Should Apply to Additional Interests Acquired in the Same Partnership

Notice 2018-67 recognizes that it may be difficult to modify existing partnerships to meet either the de minimis test or the control test, and therefore Notice 2018-67 contains a transition rule that permits exempt organizations to treat all UBTI from a partnership interest acquired prior to August 21, 2018 as a single trade or business. The Treasury Department and the IRS should clarify that this transition rule applies to additional partnership interests acquired on or after August 21, 2018 if the exempt organization held a partnership interest in the same partnership prior to August 21, 2018. Investment Funds frequently require or permit exempt organizations to fund additional capital to the same Investment Fund over a period of years. If the transition rule does not apply to additional interests in the same partnership that are acquired on or after August 21, 2018, an exempt organization would be required to bifurcate its income from a single partnership between income that is eligible for the transition rule and income that is not eligible for the transition rule. This would defeat the stated purpose of the transition rule and would be unduly burdensome for the exempt organization and the IRS to administer.

We appreciate your consideration of these comments and look forward to responding to whatever questions you may have.

Sincerely,

John Affleck-Graves
Executive Vice President
University of Notre Dame
Notre Dame, IN

FOOTNOTES

1Section 512(b)(13)(D)(i)(II) of the Code.

2Treas. Reg. § 53.4958-4(a)(2)(ii)(B)(1).

3See, e.g., Section 954(d)(3) (control of a partnership means ownership of more than 50% (by value) of the beneficial interests in the partnership), Section 2701(b)(2)(B) (control of a partnership means holding at least 50% of the capital or profits interests in the partnership or, in the case of a limited partnership, holding any interest as a general partner); Treas. Reg. § 1.52-1(c)(2)(iii) (a controlling interest in a partnership means ownership of more than 50% of the profit interest or capital interest of the partnership).

END FOOTNOTES

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