Transfers of Zero-Basis Intangibles to a Partnership

Introduction

In 2020 Treasury issued final regulations under section 721(c) to override nonrecognition treatment for some transfers of appreciated property to a partnership unless the partnership agrees to use the remedial allocation method.¹ The regulations target taxpayers that seek to shift built-in gain to related foreign partners by using a section 704(c) method other than the remedial method, often employing valuation techniques inconsistent with the arm’s-length standard under section 482.² As revealed in an improperly redacted IRS document that recently came to light, Bristol-Myers Squibb (Bristol) apparently entered into a transaction in 2012 intended to shift $3.9 billion of gain attributable to contributed zero-basis amortizable intangibles to a related foreign partner (ForeignCo).³ Under the specific antiabuse rule of section 704(c), the IRS has challenged Bristol’s use of the traditional method as unreasonable because the contributions and allocations were made with a view toward shifting the tax consequences of built-in gain among the partners in a manner that substantially reduced the present value of the partners’ aggregate tax liability.⁴ Even if the antiabuse rule is applicable, Bristol may still claim that the tax benefits of the transaction are vastly overstated because ForeignCo contributed high-value zero-basis goodwill that potentially generated offsetting remedial deductions.⁵

This report considers the application of section 704(c) principles to amortization of zero-basis intangibles contributed to a partnership. It first addresses the consequences when a partnership adopts the remedial method and elects to amortize an asset such as goodwill as if a deemed purchase had occurred for purposes of section 197, even though the asset was non-amortizable in the contributor’s hands.⁶ In light of the Bristol transaction, this report argues that the section 197 regulations should be construed as prohibiting both book and tax amortization of a contributed intangible unless the asset was amortizable in the contributing partner’s hands or the partnership elects to use the remedial method. It examines the impact of the section 721(c) regulations if a partnership is required to use the remedial method and the anti-churning rules of section 197 prevent an allocation of remedial tax deductions to a partner that is related to the contributing partner. This report concludes that if Bristol’s use of the traditional method survives scrutiny under the antiabuse rule, Congress may need to require use of the remedial method for all partnerships.

Remedial Method and Section 197

By enacting section 197 in 1993, Congress sought to eliminate disputes between taxpayers and the government concerning amortization of intangibles under prior law.⁷ Although taxpayers may now amortize the cost of most newly purchased intangibles over a 15-year recovery period, section 197(c)(2) generally bars amortization of self-created intangibles (including goodwill). In 2000 Treasury issued final regulations under section 197 addressing amortization of intangibles contributed to a partnership.⁸ The interaction between the section 197 regulations and the partnership provisions — including section 704(b) and (c) — can be exceedingly complex.⁹ While section 704(b) governs the partnership’s allocations for economic purposes, section 704(c) requires that any gain, loss, or deduction for contributed property be allocated among the partners “so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution.”¹⁰

In section 721 nonrecognition transfers, the partnership generally steps into the shoes of the transferor for purposes of amortizing contributed intangibles.¹¹ If a partner contributes an intangible that was amortizable in the partner’s hands (an amortizable section 197 intangible), the partnership may use any permissible method under section 704(c) — the traditional method, the traditional method with curative allocations, or the remedial method — to allocate amortization deductions for the intangible.¹² If a contributed intangible was non-amortizable in the hands of the contributing partner (a non-amortizable section 197 intangible), amortization deductions are allowable only if the partnership elects the remedial method under section 704(c).¹³ Under the remedial method, the contributing partner will be allocated remedial income, and the other partners (the noncontributing partners) will generally be allocated matching remedial amortization deductions.¹⁴ Remedial amortization deductions are disallowed if noncontributing partners are related to the contributing partner for purposes of the anti-churning rules of section 197(f)(9).¹⁵

The rationale for permitting remedial amortization deductions when non-amortizable goodwill is contributed to a partnership is that under the remedial method, the amortizable portion of the property is treated like newly purchased property.¹⁶ The remedial method represents a tradeoff: It is generally advantageous for the noncontributing partners but potentially disadvantageous for the contributing partner.¹⁷ If the remedial method is elected, the partnership may amortize zero-basis contributed goodwill for both book and tax purposes over the 15-year recovery period for newly purchased intangibles, even though the goodwill was non-amortizable in the contributor’s hands.¹⁸ The noncontributing partners will receive remedial tax deductions equal to their proportionate share of the book (economic) value of the contributed property. Over the same period, the contributing partner will be required to recognize an equal amount of ordinary income, rather than deferring capital gain until sale of the goodwill (or liquidation of the partnership).

By contrast, prior proposed regulations under section 197 generally denied noncontributing partners any curative or remedial tax deductions if the contributed property constituted a non-amortizable section 197 intangible in the hands of the contributing partner.¹⁹ Under the approach of the proposed regulations, the tax basis of a contributed intangible was treated as equal to its book basis for purposes of interfacing section 704(b) and (c).²⁰ Because the partnership did not receive any basis increase, an asset such as zero-basis contributed goodwill remained non-amortizable in the partnership’s hands. Technically, for purposes of section 704(b), there was no reasonable method of amortizing the book basis of such an intangible, since no existing authority would have permitted amortization absent section 197.²¹ Without book amortization, no remedial allocations could arise for purposes of section 704(c).²² The approach of the proposed regulations was fundamentally consistent with the premise of the step-in-the-shoes rule, reflecting an aggregate view that contribution of a non-amortizable zero-basis intangible does not result in an acquisition for purposes of section 197.

In response to comments that the deemed purchase construct under the remedial method should trump the step-in-the-shoes rule, Treasury reversed course in the final regulations issued in 2000.²³ When the remedial method is adopted, the final regulations allow the partnership to amortize a contributed intangible (which was non-amortizable in the contributing partner’s hands) as if a purchase had occurred for purposes of section 197.²⁴ To gain access to amortization under section 197, however, the partnership must elect to use the remedial method. Commentators suggested that allowing amortization under the remedial method would not give rise to significant potential for abuse because each dollar of tax deduction received by the noncontributing partners would be matched currently by a dollar of income taxable to the contributing partner.²⁵ Even if the partners have differing tax brackets, the specific antiabuse rule under section 704(c) should theoretically prevent abuse.²⁶

The remedial method eliminates the ceiling rule problem that would arise under the traditional method of section 704(c) allocations if zero-basis contributed goodwill were amortizable in the partnership’s hands. When contributed property is depreciable or amortizable, items of tax depreciation or amortization must be allocated first to the noncontributing partners to the extent of those partners’ economic (book) cost recovery deductions.²⁷ If there is a shortfall in matching tax items, the traditional method results in overtaxation of the noncontributing partners and undertaxation of the contributing partner. Those distortions arise from the ceiling rule, which limits the amount of income, gain, loss, or deduction that the partnership can allocate for tax purposes to the amount taken into account by the partnership.²⁸ While such mistaxation will generally be remedied upon liquidation (or sale of a partner’s interest), the timing and character of gain or loss may be affected.

The remedial method is the only method that entirely eliminates the ceiling rule problem. If the remedial method is adopted, the partnership makes remedial allocations that precisely offset ceiling-rule-limited items in amount and character.²⁹ Because the remedial items are purely notional and do not depend on the existence of actual tax items, noncontributing partners receive identical tax and book allocations; the contributing partner receives an offsetting allocation in an amount equal to the notional items allocated to the noncontributing partners. For zero-basis depreciable or amortizable property, the remedial method gives the noncontributing partners a cost basis in their proportionate shares of the contributed property, which they are deemed to purchase from the contributing partner.

The remedial method ensures that the contributing partner’s built-in gain is amortized over the economic life of the property; the additional annual remedial income allocated to the contributor is sufficient to eliminate any shortfall in the actual tax deductions allocated to the noncontributing partners. Simultaneously, the noncontributing partners are allocated additional remedial deductions equal to the contributing partner’s additional remedial income. Over the intangible’s amortization period, no partner’s economic investment is undertaxed or overtaxed. Even though the remedial method produces the correct tax and economic results, it is generally elective. Indeed, Treasury has indicated that it will not require use of the remedial method to cure ceiling rule disparities.³⁰

Bristol Transaction

In a series of transactions that culminated in the formation of a related foreign partnership, Bristol contributed zero-basis amortizable intangibles (valued at $4.6 billion) consisting of three drug patents that were expected to decline substantially in value over the patent period.³¹ ForeignCo, a related partner, contributed assets (valued at $27.6 billion) that were either (1) nondepreciable or non-amortizable; or (2) depreciable or amortizable, but with a tax basis equal to fair market value.³² More than half of ForeignCo’s contribution consisted of a zero-basis non-amortizable intangible (worth $15.3 billion) labeled by the parties as “goodwill,” presumably self-created.³³ Based on the FMV of their contributions, the partners’ percentage interests in the partnership (with total assets of $32.2 billion) were 14.27 percent and 85.73 percent, respectively.

Bristol’s zero-basis contributed intangibles were not expected to produce any tax depreciation or amortization, while ForeignCo’s contributed property would predictably produce significant amounts of tax deductions. For book purposes, the partnership amortized Bristol’s contributed intangibles over either 8.25 or 15 years — their remaining useful life in Bristol’s hands.³⁴ It elected the traditional method under section 704(c) and provided for very limited curative allocations that were unlikely to have any “practical impact.”³⁵ Because the patents were “quintessential wasting assets,” the ceiling rule allowed Bristol to shift built-in gain of $3.9 billion (85.73 percent of $4.6 billion) in the zero-basis contributed intangibles to ForeignCo.³⁶ By contrast, ForeignCo’s depreciable contributed property had sufficient tax basis to ensure that Bristol would be allocated equal amounts of book and tax depreciation for that property; because ForeignCo would bear the entire burden of any shortfall in tax depreciation, no built-in gain from ForeignCo’s depreciable property was shifted to Bristol.³⁷

Had the partnership elected the remedial method for ForeignCo’s contributed goodwill, however, there would have been a reverse shift of built-in gain to Bristol, potentially offsetting a large portion of the built-in gain that was shifted from Bristol to ForeignCo. In litigation, therefore, Bristol may claim that the ceiling rule distortion under the traditional method is greatly overstated because the partnership could have amortized the goodwill if it had elected the remedial method.

Under the remedial method, the partnership could have amortized ForeignCo’s zero-basis goodwill for both book and tax purposes.³⁸ Over the 15-year recovery period, the partnership’s amortization of the goodwill would have generated $2.2 billion of remedial deductions allocable to Bristol (14.27 percent of $15.3 billion) and matching remedial income of $2.2 billion allocable to ForeignCo. Under the remedial method, Bristol’s zero-basis contributed intangibles would also have been amortized over 15 years.³⁹ The partnership’s amortization of these contributed intangibles would have generated $3.9 billion of remedial deductions allocable to ForeignCo (85.73 percent of $4.6 billion) and matching remedial income of $3.9 billion allocable to Bristol. As shown below, Bristol would have received net remedial income of $1.7 billion, matched by a net remedial loss of $1.7 billion to ForeignCo:

	Bristol	ForeignCo
Remedial allocation (Bristol’s patents)	$3.9B	$(3.9)B
Remedial allocation (ForeignCo’s goodwill)	$(2.2)B	$2.2B
Net remedial allocation	$1.7B	$(1.7)B

Upon liquidation of the partnership, neither partner would have recognized gain or loss, since the remedial method would entirely eliminate any ceiling rule distortions.

Because of the offsetting remedial income and deductions, election of the remedial method for the partnership’s property (including the non-amortizable goodwill) would have reduced to $1.7 billion the amount of Bristol’s built-in gain shifted to ForeignCo. Rather than deferring $3.9 billion of gain under the traditional method, Bristol would have reported net remedial income of $1.7 billion over 15 years. According to representations in the outside adviser’s tax opinion, the partnership had no intention of transferring or assigning the contributed intangibles to a third party, nor did Bristol have any intention of selling its partnership interest.⁴⁰ Thus, electing the traditional method potentially allowed indefinite deferral of Bristol’s entire built-in gain of $3.9 billion, consistent with Bristol’s financial reporting of the built-in gain as permanently reinvested outside the United States.⁴¹ Because the transaction was carefully engineered to maximize the shift of built-in gain from Bristol to a zero-rate related partner, adopting the remedial method for the partnership’s assets would have partially defeated the purpose of the overall transaction.

The government has asserted that Bristol’s use of the traditional method to shift built-in gain violated the specific antiabuse rule of section 704(c). Under the antiabuse rule, an allocation method (or combination of methods) is not reasonable if the contribution of property (or the revaluation event) and the corresponding allocation of tax items for the section 704(c) property are made “with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability.”⁴² Bristol should not be permitted to claim that the transaction was somehow less abusive because the partnership could have chosen to amortize ForeignCo’s contributed goodwill under the remedial method, thereby reducing Bristol’s shifted built-in gain from $3.9 billion to $1.7 billion. Regardless of whether a “substantial” reduction is measured in relative or absolute terms, the transaction clearly produced substantial tax savings in present-value terms.⁴³

Although the section 704(c) regulations do not provide specific guidance on the “view” requirement of reg. section 1.704-3(a)(10), the requirement poses a significantly lower threshold than the principal purpose standard under the general partnership antiabuse rule of section 701.⁴⁴ When sophisticated parties structure their affairs in a manner to achieve the prohibited result, the requisite view may exist even if the taxpayer has other valid business purposes.⁴⁵ Because the parties were all related and the amortization schedule of the intangibles was known in advance, Bristol was in a position to appreciate that the traditional method would predictably shift a large amount of built-in gain to a related zero-rate taxpayer. The substantial tax savings should also have been evident to Bristol’s outside advisers, who opined on other aspects of the transaction but did not address the partnership’s choice of a section 704(c) method or the specific antiabuse rule.⁴⁶ Because the transaction was structured in such a manner as to facilitate the income shift that actually occurred, Bristol should be considered to have acted with the proscribed view, even if the larger transaction may also have served other, nontax business purposes.⁴⁷

The transaction may have been structured to exploit ambiguity under the section 197 regulations concerning the relationship between book and tax amortization when non-amortizable contributed goodwill has a zero basis and the remedial method is not elected. When the remedial method is not elected, reg. section 1.197-2(g)(4)(ii) should prevent both book and tax amortization of zero-basis non-amortizable intangibles contributed to a partnership.⁴⁸ In computing book amortization for contributed property, the section 704(b) regulations generally provide that the amount of book depreciation must bear the same ratio to the adjusted book value of the underlying property as the amount of tax depreciation bears to the adjusted tax basis of the property.⁴⁹ When non-amortizable contributed goodwill has a nonzero tax basis (and the remedial method is not elected), the book-tax conformity rule of reg. section 1.704-1(b)(2)(iv)(g)(3) clearly precludes book amortization of the contributed property.

For zero-basis contributed property, however, any reasonable method may be used to amortize book basis.⁵⁰ It has been observed that despite the dearth of guidance interpreting the reasonable-method standard, “most partnership practitioners would agree that the book basis of a zero-basis contributed property can only be amortized if such asset is a type of asset” that is amortizable “under applicable statutory, regulatory and case law.”⁵¹ Before the enactment of section 197, a partnership would have had no authority to amortize the book basis of contributed goodwill, since a purchaser of goodwill would not have been allowed to amortize the basis of the goodwill for tax purposes. Similarly, a partnership “could not amortize the book basis of zero tax basis land or stock” contributed to a partnership.⁵² If the zero-basis contributed goodwill is treated like non-amortizable land or stock, a failure to elect the remedial method would bar any book amortization deductions under the section 197 regulations; and because both book and tax amortization would be zero, no built-in gain would shift from ForeignCo to Bristol.

Although the regulations are not explicit, reg. section 1.197-2(g)(4) should be read as setting forth rules for book amortization of contributed intangibles.⁵³ Under this reading, the book basis of a contributed intangible is amortizable only if (1) the asset was amortizable in the contributing partner’s hands, or (2) it was not amortizable in the contributing partner’s hands and the partnership elects the remedial method. Some commentators maintain, however, that reg. section 1.197-2(g)(4)(ii) bars only tax — not book — amortization when the remedial method is not elected. Under this view, a zero-basis non-amortizable intangible “cannot be amortized for tax purposes (unless the remedial [method] is elected) but can be amortized for book purposes even without adopting the remedial method.”⁵⁴ This position seems anomalous, because it would permit book amortization only of zero-basis (not nonzero basis) non-amortizable intangibles when the partnership follows the capital account maintenance rules and does not elect the remedial method.

As applied to the Bristol transaction, the technical issue is whether the zero-basis non-amortizable goodwill could be amortized in the partnership’s hands for book purposes even though the partnership used the traditional method. Given the lack of clarity under the section 197 regulations, Bristol may claim that it was reasonable to write off the book value of the non-amortizable goodwill for purposes of section 704(b). Treating the zero-basis contributed goodwill as amortizable for book purposes would create a section 704(c) ceiling rule problem that would not otherwise exist, because book amortization would vastly exceed tax amortization. Bristol would be allocated a share of book amortization and zero tax amortization. Over time, amortization of the book basis of the goodwill would eliminate ForeignCo’s built-in gain in the asset, and a portion of the built-in gain would be shifted to Bristol equal to Bristol’s percentage share of book amortization. By contrast, if the goodwill were treated as non-amortizable for book and tax purposes, no ceiling rule problem would arise because both book and tax amortization would be zero. The pre-contribution gain of $15.3 billion (the excess of the book value over the zero-tax basis) would be taxed only to ForeignCo under section 704(c) principles, and no portion of the gain would be shifted to Bristol.

In effect, book amortization would treat the contributed goodwill as a wasting asset, analogous to Bristol’s contributed intangibles. Under the value-equals-basis presumption, Bristol would be entitled to $2.2 billion less on liquidation (14.27 percent of $15.3 billion book amortization) if the contributed goodwill were fully amortized for book purposes.⁵⁵ Correspondingly, Bristol’s deferred gain on liquidation, under the traditional method, would be reduced from $3.9 billion to $1.7 billion.⁵⁶ The only cost to Bristol would be the shift of economic value to ForeignCo, if the FMV of the goodwill were actually greater than zero. Book amortization would create the equivalent of a built-in tax loss for Bristol equal to the excess of Bristol’s share of book amortization ($2.2 billion) over its share of tax amortization (zero). Bristol would realize the tax loss by reporting $2.2 billion less tax gain on liquidation. Thus, the partnership’s use of the traditional method — coupled with book amortization of the zero-basis non-amortizable goodwill — might produce an even more favorable result than if the remedial method were elected.

Bristol’s gain on liquidation would be reduced because the allocation of book (but not tax) deductions for amortization of the zero-basis goodwill would give rise to a ceiling rule limitation equal to the disparity between Bristol’s share of the book amortization and the partnership’s zero tax amortization. The basis of Bristol’s partnership interest would thus be $2.2 billion higher than if Bristol had received tax deductions to match its share of book deductions from the partnership’s zero-basis non-amortizable goodwill. If the partnership fully amortized the book value of the goodwill, there would no longer be any book-tax disparity, eliminating the section 704(c) taint. In the unlikely event of a sale of the goodwill, Bristol would be allocated book and tax gain of $2.2 billion if the goodwill retained its original value. The book gain would precisely offset Bristol’s share of book amortization (thereby restoring Bristol’s book capital account), and Bristol’s basis in its partnership interest would be increased by tax gain of $2.2 billion. Thus, Bristol would again be taxed on total gain of $3.9 billion ($2.2 billion on sale of the goodwill and $1.7 billion on liquidation).

Compared with the remedial method, the traditional method maximized Bristol’s tax savings: (1) no portion of Bristol’s built-in gain attributable to its zero-basis contributed intangibles would be accelerated, and (2) Bristol’s gain upon liquidation could be reduced from $3.9 billion to 1.7 billion (assuming book amortization of $2.2 billion from the zero-basis goodwill). The government should require Bristol to explain whether the partnership treated the book value of the goodwill as amortizable for purposes of section 704(b) even though it used the traditional method. Although the partnership’s valuation experts may have determined that the contributed goodwill would be worthless at the end of 15 years, no authority permits amortizing the book basis of non-amortizable zero-basis goodwill under the traditional method. Given the myriad technical issues under sections 197, 704(b), and 704(c), Bristol’s tax advisers were presumably consulted concerning the relative merits of choosing the traditional or the remedial method.⁵⁷ In this light, the apparent failure of those advisers to address the choice of the section 704(c) method or the specific antiabuse rule under section 704(c) seems even more remarkable.

Impact of Section 721(c) Regulations

In 1997 Congress enacted section 721(c), authorizing Treasury to deny nonrecognition treatment under section 721(a) for some transfers of appreciated property to a partnership if the gain, when recognized, would be includable in the gross income of a person other than a U.S. person.⁵⁸ In Notice 2015-54, 2015-34 IRB 210, Treasury took aim at some taxpayers that claimed to be able to avoid U.S. tax on income or gain from property that was contributed by U.S. persons but allocated to related foreign partners, consistent with sections 704(b), 704(c), and 482.⁵⁹ According to the notice, “many of these taxpayers choose a section 704(c) method other than the remedial method and/or use valuation techniques that are inconsistent with the arm’s length standard.”⁶⁰ In 2020 Treasury issued final regulations under section 721(c) that override the general nonrecognition rule of section 721(a) if a U.S. person contributes appreciated property to a partnership controlled by the transferor and related foreign partners.⁶¹ Nonrecognition treatment under section 721(a) is reinstated, however, if the partnership agrees to use the gain deferral method for built-in gain from all section 721(c) property, as defined in the section 721(c) regulations.⁶² The gain deferral method is a modified version of the remedial method authorized under the section 704(c) regulations. As indicated in Notice 2015-54, the remedial method is the most accurate method of ensuring that built-in gain is ultimately taxed to the contributing partner.⁶³

Some practitioners asserted that the section 721(c) regulations were unnecessary or invalid because they exceeded Treasury’s authority by requiring the remedial method.⁶⁴ On balance, those objections to the regulations are not persuasive. Because Treasury could have required immediate gain recognition, the mandatory remedial method offers taxpayers the choice of preserving nonrecognition treatment under section 721(a) or complying with the requirements under the section 721(c) regulations. The argument that the section 721(c) regulations were unnecessary overlooks the failure of the existing section 704(c) regulations to ensure that a contributing partner will necessarily bear the tax consequences of contributing property with built-in gain. Allowing taxpayers wide latitude in choosing section 704(c) methods raises particular concerns in the case of related partners — one or more of whom may be foreign — given the overall alignment of the partners’ tax and economic interests and the enhanced potential for tax arbitrage.⁶⁵ In light of the highly tax-charged nature of these income-shifting transactions, Treasury reasonably concluded that a mandatory rule was needed, but it waited two decades before exercising its authority under section 721(c).

If the final section 721(c) regulations were applicable to the Bristol transaction,⁶⁶ Bristol (a U.S. transferor) would have a choice either to recognize built-in gain of $3.9 billion immediately upon contribution of the zero-basis intangibles or to elect the gain deferral method. Thus, Bristol could preserve nonrecognition treatment under section 721 only by agreeing to include $3.9 billion of remedial income over 15 years, triggering $3.9 billion of remedial deductions to ForeignCo over the same period. The section 721(c) regulations eliminate the ability of taxpayers in Bristol’s situation to shift built-in gain to a related zero-rate foreign partner by exploiting the ceiling rule under the traditional method. Because the section 721(c) regulations continue to permit deferral rather than requiring immediate gain recognition, transfers by U.S. persons to a controlled foreign partnership nevertheless remain tax advantageous compared with direct transfers of intangibles to a foreign subsidiary.⁶⁷

In the case of a U.S. transferor’s contribution of zero-basis goodwill subject to the anti-churning rules of section 197 (a non-amortizable section 197(f)(9) intangible), the final section 721(c) regulations modify the operation of the remedial method.⁶⁸ Under the gain deferral method, the partnership may amortize the excess book value of the contributed section 197(f)(9) intangible as if the property were newly purchased.⁶⁹ Remedial tax deductions attributable to the non-amortizable section 197(f)(9) intangible are allowed, however, only to noncontributing partners that are unrelated to the U.S. transferor. Noncontributing partners that are related to the U.S. transferor may not receive remedial tax deductions attributable to the non-amortizable section 197(f)(9) intangible.⁷⁰ In lieu of disallowed remedial tax deductions, ceiling-rule-limited related partners receive a suspended section 743(b)-type adjustment of equal amount. The special adjustment to the basis of the partnership’s property is solely for the benefit of the related partners and does not affect the common basis of the partnership’s property (or the computation of partnership items under section 703).⁷¹ When the non-amortizable section 197 intangible is later sold, the section 743(b)-type adjustment is taken into account in determining the related partners’ taxable gain.⁷² The prohibition on remedial tax deductions allocable to related partners does not, however, reduce the amount of remedial income allocable to the U.S. transferor.⁷³ As a result, the contributing partner’s income inclusion will no longer necessarily be matched by a dollar of amortization deductions by the noncontributing partners.

The anti-churning rules are intended to prevent the amortization of some intangibles that are not acquired after the effective date of section 197 in a transaction giving rise to a significant change in ownership or use.⁷⁴ In general, section 197(f)(9) prohibits the amortization of goodwill and going concern value that was non-amortizable before the enactment of section 197. The prohibition on amortization continues to apply if section 197(f)(9) intangibles are transferred to a related party.⁷⁵ When section 197(f)(9) intangibles are contributed to a partnership, the section 197 regulations provide that a noncontributing partner may generally receive remedial amortization deductions for that property. A noncontributing partner that is related to the contributing partner, however, may not receive those remedial amortization deductions.⁷⁶ The final 2000 regulations gave rise to considerable confusion concerning the interaction between the section 197 prohibition and the remedial method.⁷⁷

On one hand, the final 2000 regulations could be interpreted as meaning that the partnership creates neither a remedial item of deduction for the related partner nor an item of remedial income for the contributing partner for contributed section 197(f)(9) intangibles. While that reading would arguably be fair and simple to apply, it would require modifying the remedial method to reflect section 197 principles.⁷⁸ On the other hand, the final 2000 regulations can be read as not altering the mechanics of the remedial method based on the partners’ attributes but instead as denying any tax deduction for a related partner’s share of amortization.⁷⁹ Under this reading, the partnership would create remedial items of deduction for the related partner and offsetting remedial income for the contributing partner. The remedial item allocated to the related partner would not be deductible for tax purposes, but the offsetting remedial item allocated to the contributing partner would be fully includable in income. This reading is consistent with the preamble to the final 2000 regulations, which provides that related partners are not eligible to receive remedial allocations under section 704(c) “that are deductible for federal income tax purposes.”⁸⁰

In promulgating the section 721(c) regulations, Treasury was forced to resolve the ambiguity under the final 2000 regulations.⁸¹ Commentators maintained that the contributing partner should not be required to recognize remedial income if related partners received nondeductible remedial amortization.⁸² Treasury rejected that comment based on the concern that excluding section 197(f)(9) intangibles would give taxpayers an incentive to overvalue that property while undervaluing related but separate section 721(c) property that remained subject to the gain deferral method. Although taxpayers had an incentive to minimize the value of non-amortizable goodwill and going concern value before 1993, the enactment of section 197 created the opposite incentive, encouraging taxpayers to claim that such value “constitutes a large percentage — even the vast majority — of an enterprise’s value.”⁸³ Treasury also concluded that changing the language of the section 197 regulations to permit remedial allocations of deductible amortization to related partners would contravene the purpose of the section 197 anti-churning rules.

For contributed section 197(f)(9) intangibles, permitting a section 743(b)-type adjustment mitigates the harshness of requiring the contributor to include remedial income without any corresponding remedial tax deduction to related partners. The section 743(b)-type adjustment is intended to prevent overtaxation of related partners if the partnership later sells the amortized section 197(f) intangible and recognizes taxable gain attributable to pre-contribution appreciation. Without the section 743(b)-type adjustment, ceiling-rule-limited related partners would be taxed on a share of the contributed property’s built-in gain for which they were denied tax amortization deductions.

For example, assume that Bristol (rather than ForeignCo) had contributed zero-basis goodwill (worth $15.3 billion) constituting a section 197(f)(9) intangible in the contributor’s hands, and that the partnership elected the gain deferral method.⁸⁴ In this situation, ForeignCo would be allocated nondeductible remedial amortization and Bristol would be allocated corresponding remedial income. The remedial amortization deductions would reduce ForeignCo’s book capital account but would be nondeductible for tax purposes.⁸⁵ Because book amortization of the section 197(f)(9) intangible would reduce or eliminate any disparity between the property’s book and tax basis, a subsequent sale would generate equal amounts of tax and book gain, allocable to the partners in accordance with their percentage interests in the partnership. ForeignCo would be entitled to a section 743(b)-type adjustment equal to the prior nondeductible remedial amortization, and the special basis adjustment — solely for the benefit of the related partner — would precisely eliminate ForeignCo’s share of tax gain on sale of the goodwill. If the goodwill were fully amortized for book purposes but retained its value at the time of contribution, Bristol would be required to recognize the entire amount of built-in gain in the form of (1) remedial income to match the nondeductible remedial amortization allocated to ForeignCo, plus (2) Bristol’s share of taxable gain upon sale of the goodwill.⁸⁶

While the precise nature of ForeignCo’s contributed goodwill is unclear, the asset may have been acquired from Bristol as part of the larger transaction culminating in the creation of the foreign partnership. If Bristol created the non-amortizable intangible before 1993, the asset would continue to be a tainted section 197(f)(9) intangible in the hands of ForeignCo, a related party. As clarified by the section 721(c) regulations, the final 2000 regulations under section 197 should be interpreted as preventing a related partner (Bristol) from receiving deductible remedial amortization. Thus, if the anti-churning rules apply, Bristol’s shifted built-in gain of $3.9 billion would not be reduced by any remedial tax deductions, even if the partnership elected the remedial method for the contributed goodwill. Although the final 2000 regulations did not address whether a related partner should receive a section 743(b)-type adjustment for disallowed remedial tax deductions, no such adjustment would arise unless the partnership sold the goodwill, which was unlikely to occur.

Conclusion

The section 197 regulations provide that if zero-basis intangibles are contributed to a partnership, the partnership may not amortize the intangible unless it was amortizable in the hands of the contributor or the partnership elects the remedial method. If the partnership chooses the traditional method for an asset, such as self-created goodwill, that was non-amortizable in the contributor’s hands, reg. section 1.197-2(g)(4)(ii) should be read as prohibiting both book and tax amortization of the contributed intangible. In the case of contributed self-created goodwill, the partnership should not be permitted to amortize the asset for purposes of section 704(b) or to make section 704(c) allocations of amortization (unless the remedial method is elected). When the gain deferral method applies under section 721(c), the partnership amortizes the intangible for both book and tax purposes, but a related partner may not receive remedial tax deductions for anti-churning property. If the Bristol transaction is not caught by the section 704(c) antiabuse rule,⁸⁷ Congress should consider requiring the remedial method to prevent taxpayers from exploiting flexible choice of section 704(c) methods. Unless the specific antiabuse rule is effective, retaining the traditional method under section 704(c) can no longer be justified on grounds of avoiding complexity.