onus puliation - webinars, webcasts, lms, elearning ...media01.commpartners.com/wk...

Thank you for attending today’s CCH Webinar!

Please check out additional programs at www.cchwebinars.com

BONUS PUBLICATION for

Using CCH® IntelliConnect to Conduct International Tax Research

International Tax Journal

(January – February 2016)

http://www.cchwebinars.com/

Published Bimonthly by CCH, a part of Wolters Kluwer

INTERNATIONALTAX JOURNALADDRESS SERVICE REQUESTED

J A N U A RY –F E B R U A RY

4025 West Peterson AvenueChicago, IL 60646

INTERNATIONALTAX JOURNAL

10028608-0190ISSN 0097-7314PUBLISHED BY

SFI-00993

Subpart F: When Is Services Income Analyzed as Sales Income?

The Dutch Implementation of Country-by-Country Reporting

THE IRS ISSUES NEW CODE SEC. 956 REGULATIONS

NEW 871(M) REGULATIONS FINALIZE DIVIDEND-EQUIVALENT PAYMENT

WITHHOLDING RULES FOR EQUITY DERIVATIVES

IRS PLANS TO ISSUE BUILT-IN GAIN, ALLOCATION REGULATIONS FOR

TRANSFERS TO PARTNERSHIPS WITH RELATED FOREIGN PARTNERS

THE NEW GLOBAL FATCA: AN OVERVIEW OF THE OECD’S

COMMON REPORTING STANDARD IN RELATION TO FATCA

1

INTERNATIONALTAX JOURNAL V o L . 4 2 , N o . 1 J a N u a r y – F e b r u a r y 2 0 1 6

A Note From the editor-iN-ChieFSubpart F: When is Services income Analyzed as Sales income?By Lowell D. Yoder 3ColumNSthe NetherlandsBy Peter H.M. Flipsen and Jurgen J. van Beest 5ArtiCleSthe irS issues New Code Sec. 956 regulationsBy John D. McDonald, Stewart R. Lipeles and Samuel Pollack 9New 871(m) regulations Finalize dividend-equivalent Payment Withholding rules for equity derivativesBy David S. Miller and Jason Schwartz 17irS Plans to issue Built-in Gain, Allocation regulations for transfers to Partnerships with related Foreign PartnersBy David Forst 29the New Global FAtCA: An overview of the oeCds Common reporting Standard in relation to FAtCABy Eschrat Rahimi-Laridjani and Erika Hauser 31

InternatIonal tax Journal January–February 20162

Managing EditorJoy Hail

Coordinating EditorBarbara Mittel

Editorial assistantRaghavendra Kaup

ProduCtionCraig Arritola

layout and dEsignPublishing Production & Design Services

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional service and that the authors are not offering such advice in this publication. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. All views expressed in the articles and columns are those of the author and not necessarily those of Wolters Kluwer or any other person.

For article submission guidelines, contact Lowell D. Yoder, McDermott, Will & Emery 227 West Monroe Street Chicago, IL 60606 or send e-mail to [email protected].

To order call (800) 449-8114 or visit CCHGroup.com

THE INTERNATIONAL TAX JOURNAL (USPS# 673-030) is published bimonthly by Wolters Kluwer, 4025 W. Peterson Ave., Chicago, Illinois 60646. Subscription inquiries should be directed to 4025 W. Peterson Ave., Chicago, IL 60646. Telephone: (800) 449-8114 Fax: (773) 866-3895. Email: [email protected]. PostMastEr: send address changes to JOURNAL OF INTERNATIONAL TAX, 4025 W. Peterson Ave., Chicago, ILLINOIS 60646. January–February 2016. Vol. 42, No. 1. Copyright ©2016 CCH Incorporated and its affiliates. All rights reserved. Photocopying or reproducing in any form in whole or in a violation of federal copyright law and is strictly forbidden without the publisher’s consent. No Claim is made to original governmental works: however, within this product or publication, the following are subject to Wolters Kluwer’s copyright: (1) the gathering, compilation, and arrangement of such governmental materials; (2) the magnetic translation and digital conversion of data, if applicable: (3) the historical, statutory, and other notes and references; and (4) the commentary and other materials.

CCH Journals and NewslettersEmail Alert for the Current Issue

CCHGroup.com/Email/JournalsSign Up Here...

Advisory BoArdEditor-in-ChiEf

lowell d. yoderMcDermott Will & Emery LLPChicago, IL

unitEd statEs MEMBErs

reuven s. avi-yonahUniversity of Michigan Law SchoolAnn Arbor, MI

Barton BassettMorgan LewisPalo Alto, CA

J. Michael CornettKPMGWashington, DC

Paolo M. dauMcDermott Will & Emery LLPPalo Alto, CA

nicholas J. denovioLatham & Watkins LLPWashington, DC

tadd fowlerThe Procter & Gamble CompanyCincinnati, OH

James P. fullerFenwick & West LLPPalo Alto, CA

Marc J. gersonMiller & Chevalier CharteredWashington, DC

Peter a. glicklichDavies Ward Phillips & Vineberg LLPNew York, NY

irwin halpernDeloitte Tax LLPWashington, DC

l. g. (Chip) harterPricewaterhouseCoopers LLPWashington, DC

harry (hal) J. hicks iiiSkadden Arps Slate Meagher & Flom LLPWashington, DC

Patrick a. JackmanKPMGNew York, NY

sam KaywoodAlston & Bird LLPAtlanta, GA

John P. KennedyCVS Caremark CorporationProvidence, RI

lawrence lokkenUniversity of Florida College of LawGainesville, FL

Michael J. MillerRoberts & Holland LLPNew York, NY

douglas MchoneyPricewaterhouseCoopers LLPCincinnati, OH

James M. o’BrienBaker & McKenzie LLPChicago, IL

Mark a. oatesBaker & McKenzie LLPChicago, IL

Edward C. osterberg, Jr.Mayer BrownHouston, TX

robert J. PeroniUniversity of Texas Law SchoolAustin, TX

Philip f. PostlewaiteNorthwestern University Law SchoolChicago, IL

James a. riedyMcDermott Will & Emery LLPWashington, DC

steven surdellErnst & Young LLPChicago, IL

Philip tretiakWells FargoNew York, NY

forEign MEMBErs

Peter h.M. flipsenSimmons & SimmonsRotterdam, The Netherlands

Bruno gouthiereCMS Bureau Francis LeFebvreParis, France

James somervilleA & L Goodbody SolicitorsDublin, Ireland

William h. MorrisGeneral Electric CompanyLondon, England

henri torrioneLenz & StaehelinGeneva, Switzerland

toshio MiyatakeAdachi, Henderson, Miyatake & FujitaTokyo, Japan

J. scott WilkieBlake, Cassels & Graydon LLPToronto, Ontario

SFI-00993

Editor-in-ChiEfA N o t e F r o m t h e

LoweLL D. YoDer is a Partner in the Chicago office of McDermott Will & Emery LLP, and head of the U.S. & Inter-national Tax Practice Group.

JANuAry–FebruAry 2016 3©2016 CCH InCorporated and Its affIlIates. all rIgHts reserved.

Subpart F: When Is Services Income Analyzed as Sales Income?U.S. shareholders of a controlled foreign corporation (CFC) are required to include in their gross income the Subpart F income of the CFC. In relevant part, Subpart F income is defined as including certain sales and services income.1

Separate rules are provided for determining whether an item of sales income is Subpart F income or an item of services income is Subpart F income.2 Therefore, a particular item of income must first be characterized as sales income or as services income before applying the specific Subpart F income definitional category.3 For example, income from the sale of products is analyzed under the Subpart F sales income rules, whereas fees for the performance of certain functions for another person generally are analyzed under the Subpart F services income rules.

Code Sec. 954(d) contains a unique rule that requires analysis of certain services income as sales income. Subpart F sales income is defined as income “whether in the form of profits, commissions, fees, or otherwise” derived in connection with:1. the purchase of personal property from a related person and its sale to any person,2. the sale of personal property to any person on behalf of a related person,3. the purchase of personal property from any person and its sale to a related person, or4. the purchase of personal property from any person on behalf of a related person,where the property is manufactured outside, and sold for use outside, the CFC’s country of organization.4 The CFC would earn commissions or fees under sce-narios 2 and 4 from selling or purchasing property on behalf of another person. These fees are analyzed as sales income for Subpart F purposes5 but would be treated as services income for other purposes of the Code.6

From the above language of the Code it follows that for services income to be analyzed as sales income, the CFC must engage in the activities that it would engage in if it had actually sold property, or had actually purchased property, on its own account. When comparing scenarios 1 and 2, the CFC in both cases must engage in “the sale of personal property to any person,” and the only difference is that in scenario 1, the CFC takes ownership of the property from a related person, and in scenario 2, the CFC does not take ownership of the property. Similarly, when comparing scenarios 3 and 4, the CFC in both cases must engage in “the purchase of personal property from any person,” and the only difference is that in scenario 3, the CFC takes ownership of the property from another person and transfers it to a related person, and in scenario 4, the CFC does not take owner-ship of the property.

The legislative history confirms the intended scope of applying Code Sec. 954(d) to commission or fee income as a transaction where a CFC sells or purchases property, not in its own name, but in the name of a related person. The Senate


A Note From the editor-iN-ChieF

report states that Subpart F sales income “is income from the purchase and sale of personal property if the property is either purchased from a related person or sold to a related person” or income from “similar cases where the controlled foreign corporation does not take title to the property but acts on a fee or commission basis.” The Senate report further states: “The sales income with which your committee is primarily concerned is income of a selling subsidiary (whether acting as principal or agent).”7

This Subpart F characterization rule can be consequen-tial. Assume a Swiss CFC receives fees for the performance of services in Switzerland identifying suppliers, arranging shipping and performing quality control with respect to products purchased from a German supplier by its U.S. parent. The Swiss CFC performs all of its activities in Swit-zerland, and the products are manufactured in Germany. If the fee income is analyzed as services income, it would not be Subpart F income because Subpart F services income

does not include income from services performed in the CFC’s country of organization. On the other hand, if the fee income were analyzed as sales income (by reason of being derived from purchasing products on behalf of the U.S. parent), it would be Subpart F income because the products are both manufactured and sold for use outside the CFC’s country of organization (assuming the Swiss CFC’s activities do not rise to the level of “substantial contribution” manufacturing).8

Once an item of income is properly characterized as services income or as sales income, it is analyzed only under the relevant Subpart F income category, even if the income qualifies for an exception from Subpart F treatment under that category. For example, purchasing or selling commissions that are treated as sales income but qualify for the manufacturing exception would not also be analyzed as services income.9

Thus, it is critical to determine whether a particular item of services income is analyzed as sales income under the unique characterization rule of Subpart F. The essential criterion for treating commissions and fees as purchasing or selling income for Subpart F purposes is that the CFC engages in the activities it would engage in if were actually purchasing a product (e.g., contacting suppliers, negotiat-ing terms of contracts and entering into contracts), only on behalf of another person, or the activities it would engage in if it were actually selling a product (e.g., soliciting a sale, negotiating the terms of contracts and entering into contracts), only on behalf of another person.10

Thus, it is critical to determine whether a particular item of services income is analyzed as sales income under the unique characterization rule of Subpart F.

EndnotEs

1 Code Secs. 951(a), 952(a) and 954(a).2 Code Sec. 954(d) (sales) and (e) (services).3 An item of income is characterized based

on the substance of the transaction, taking into account all facts and circumstances. reg. §1.954-1(e).

4 the regulations list the same four transactions and use the same descriptive language without any elaboration. reg. §1.954-3(a). the regula-tions provide an exception for income from the sale of products manufactured by the CFC. reg. §1.954-3(a)(4).

5 See reg. §1.954-3(a)(1)(iii), Ex. 3 (commis-sions received by a CFC for selling property as an agent for its parent analyzed as sales income); ltr 7947050 (Aug. 23, 1979) (com-missions received by a CFC for selling products on behalf of a related person analyzed as

sales income); tAm 8536007 (may 31, 1985) (commissions received by a CFC for purchas-ing products on behalf of a related person analyzed as sales income).

6 See British Timken Ltd., 12 tC 880, dec. 16,992 (1949), acq. 1949-2 CB 1 (sales commissions received pursuant to a consign-ment arrangement characterized as services income); rev. rul. 60-55, 1960-1 CB 270 (commissions paid to a foreign corporation for securing purchase orders from foreign customers characterized as compensation for services); CCA 201343020 (Nov. 1, 2013) (income derived from services involving a marketing structure was services income, where the activities performed “involve[d] finding, sponsoring, and ultimately uniting buyers and sellers”).

7 S. rep. No. 1881, 87th Cong., 2d Sess. 84 (1962), at 790 (emphasis added).

8 other definitional differences include that the Subpart F sales rules contain a branch rule, but also provide a manufacturing exception, while the Subpart F services regulations contain broad deemed related person transaction rules.

9 See rev. rul. 86-155, 1986-2 CB 134; ltr 7947050 (Aug. 23, 1979); ltr 8536007 (may 31, 1985); ltr 201332007 (Apr. 15, 2013); ltr 201325005 (may 28, 2013).

10 Cf., FAA 20153301F (Aug. 14, 2015) (the irS, without legal analysis or any discernible rea-soning, rejected the taxpayer’s treatment of certain intercompany referral fees as services income for purposes of applying Code Sec. 954, and instead analyzed the fees as sales income under Code Sec. 954(d)).

January–February 2016 5©2016 CCH InCorporated and Its affIlIates. all rIgHts reserved.

PEtEr H.M. FliPsEn is a tax Partner at Simmons & Simmons llP in Amsterdam. he specializes in m&A and corporate (re-)structuring.

JurgEn J. van BEEst is a tax Advisor at Simmons & Simmons llP in Amsterdam.

The Netherlandsthe dutch implementation of Country-by-Country reporting

By Peter H.M. Flipsen and Jurgen J. van Beest

1. IntroductionFollowing the 2013 report addressing Base Erosion and Profit Shifting (BEPS), the Organisation for Economic Cooperation and Development (OECD) released its final reports on BEPS on October 5, 2015.1 The 13 Action Plans in this report address several international tax issues and include new or reinforced international standards to help governments and tax authorities to tackle BEPS.

One of the Actions Plans is Action 13 on Country-by-Country (CBC) re-porting and additional transfer pricing documentation requirements, which is aimed at enhancing transparency by multinational enterprises (MNE) towards tax administrations.2

In order to achieve this goal, the OECD has developed a three-tiered standard-ized approach requiring MNEs to provide tax administrations with (i) a CBC report that provides an annual statement of the amount of revenue, profit and tax paid for each tax jurisdiction in which the MNE carries on a business, (ii) high-level information regarding their business operations (a “master file”), and (iii) detailed transactional transfer pricing documentation (a “local file”).3

In September 2015, the Dutch government released its tax bill 2016, which contained draft legislation implementing CBC reporting and additional transfer pricing documentation requirements in the Dutch Corporate Income Tax Act 1969 (CITA) articles 29b to 29h applicable to fiscal years starting on or after January 1, 2016 (the “Dutch Legislation”).4 The tax bill 2016 entered into force on January 1, 2016.

This article provides an analysis of the Dutch Legislation on CBC reporting and additional transfer pricing requirements, which is largely based on the model legislation provided by the OECD.

2. CBC Reporting

2.1. Scope of the LegislationPursuant to article 29c CITA of the Dutch Legislation, a Dutch group company must prepare a CBC report if:


the NetherlANdS

(A) it is a resident of the Netherlands for tax purposes;(B) it can be deemed the “ultimate parent company”

of an MNE group that operates in more than one country; and

(C) the qualifying group had a consolidated gross revenue of at least EUR 750 million in the previous fiscal year.

The consolidated gross revenue mentioned under 2.1(C) above is, in principle, the consolidated gross rev-enue as reflected in the consolidated financial statements of the MNE group. The Dutch Legislation follows the definition of “total consolidated group revenue” as used in BEPS Action 13, which definition includes revenues from sales of inventory and properties, services, royalties, interest, premiums and any other (incidental) amounts. Revenues excludes payments received from other group companies that are treated as dividends in the payer’s tax jurisdiction.5

2.2. Ultimate Parent Company

The “ultimate parent company” is described in 29b, section e, CITA as: (i) a company that owns, directly or indirectly, a sufficient interest in one or more companies of the MNE group such that it is required to prepare consolidated fi-nancial statements under accounting principles generally applied in its jurisdiction of tax residence, or would be so required if its equity interests were traded on a public securities exchange in its jurisdiction of tax residence, and (ii) there is no other company of the MNE group that owns, directly or indirectly, an interest described in section (i) above in the first mentioned company.

2.3. Surrogate Parent Company

Even if a Dutch company is not the ultimate parent of the group, the Dutch company can still be required to file a CBC report in the Netherlands if it meets the requirements

of article 29b, section f, CITA in conjunction with article 29c, section 2, CITA:(A) the country in which the ultimate parent company

is a tax resident has not established CBC reporting obligations;

(B) the country in which the ultimate parent company is a tax resident has not concluded an agreement with the Netherlands regarding automatic exchange of CBC reports (at the latest 12 months after the last day of the fiscal year); or

(C) the Dutch tax inspector has informed the Dutch com-pany that the country in which the ultimate parent company is established systematically fails to comply with CBC reporting obligations.

If any one of the above conditions is fulfilled, the Dutch group company that would need to provide the CBC report is referred to as the “surrogate parent company.”

Article 29d, section 1, CITA prescribes that a Dutch company that is part of an MNE group has to notify the tax inspector before the last day of the fiscal year whether it is the ultimate or the surrogate parent com-pany of an MNE group. If a Dutch company is not the ultimate or surrogate parent of an MNE group, it has to disclose to the tax inspector before the last day of the fiscal year the identity and the tax residency of its ultimate parent company, as stated in article 29d, section 2, CITA.

2.4. Dutch Surrogate Parent Company

If the MNE group has multiple Dutch group companies, and any one of the conditions under 2.3(A)–(C) is met, the MNE group can designate one of these Dutch group companies to be the surrogate parent company under article 29c, section 3, CITA.

If any one of the conditions under 2.3(A)–(C) is ful-filled, a Dutch group company would not be required to provide a CBC report if a surrogate parent company provides the CBC report to the tax administration of the country in which it is a resident and the following condi-tions of article 29c, section 4, CITA are met:(A) the country of the surrogate parent company requires

filing of a CBC report conforming to the Dutch re-quirements for a CBC report;

(B) the country of the surrogate parent company has con-cluded an agreement with the Netherlands regarding automatic exchange of CBC reports (at the latest 12 months after the last day of the fiscal year);

(C) the country of the surrogate parent company has not informed the Dutch tax authorities of any systematic failure to comply;

CBC reporting and the additional transfer pricing documentation requirements should make it easier for tax administrations to identify whether MNEs have engaged in transfer pricing and other practices that have the effect of artificially shifting profits to favourable tax jurisdictions.

©2016 CCH InCorporated and Its affIlIates. all rIgHts reserved.January–february 2016 7

(D) the country of the surrogate parent company has been notified by the group company residing in that country that it is the surrogate parent company; and

(E) the Dutch tax authorities have been notified by the Dutch group company that none of the Dutch group companies is the ultimate or surrogate parent company.

2.5. The CBC Report

The CBC report is a report (in English or in Dutch) on the MNE group as a whole that contains the following informa-tion for each country in which the MNE group is active:(A) the revenue, profits before taxation, income tax pay-

able, income tax according to the annual accounts, paid-up capital, accumulated earnings, number of employees and the tangible fixed assets other than cash or cash equivalents; and

(B) a description of each company of the MNE group noting the country of which the group company is a tax resident and, if it is different, the country under whose laws the entity has been incorporated as well as the nature of the main business activities of the group company.

Although further guidance regarding the form and con-tent of the CBC report will be provided through detailed implementation rules, the OECD has provided for a tem-plate, which will function as a basis for the Dutch template.6

If a Dutch company is the ultimate or surrogate par-ent company, according to article 29c, section 1, CITA, it has to file the CBC report within 12 months after the last day of the fiscal year starting on or after January 1, 2016. The filed CBC report will be exchanged automati-cally with the countries in which the MNE is active and with which the Netherlands has concluded information exchange agreements.

The Dutch Legislation prescribes that the Dutch tax authorities may not make a transfer pricing adjustment on the basis of the CBC report as stated in article 29f CITA. The Dutch tax authorities can only make a transfer pric-ing adjustment if a transaction is not arm’s length within the meaning of article 8b CITA and the relevant transfer pricing decree of the State Secretary of Finance.

2.6. Penalties in the Event of Noncompliance with the Proposed CBC RulesIf a Dutch ultimate or surrogate parent company fails to satisfy the requirement to submit the CBC report to the Dutch tax authorities, this will be regarded as a criminal offence. This could result in liability to pay a fine of up to EUR 8,100 and/or to a term of imprisonment of not

more than six months on the basis of article 68, section 1, General Tax Act (GTA). If a company intentionally fails to comply with the new CBC rules or such failure is due to gross negligence, it could be liable to pay a fine of up to EUR 20,250 and/or to a term of imprisonment of not more than four years subject to article 29h CITA in conjunction with article 69, section 1, GTA. Criminal prosecution will generally be reserved for the most serious cases.

3. Additional Transfer Pricing Documentation: Master File and Local File

In addition to CBC reporting, article 29g CITA of the Dutch Legislation introduces more stringent transfer pric-ing documentation requirements for Dutch companies which are part of an MNE group that has a consolidated gross revenue exceeding EUR 50 million in the fiscal year preceding the year to which the tax return applies. Any such Dutch company must prepare a master file and a local file, which have to be available at the level of the Dutch group company at the moment of filing the tax return.

3.1. Master File

According to article 29g, section 2, CITA, the master file must contain an overview of the MNE group business, including the nature of its business activities, its general transfer pricing policy and its global allocation of income and economic activities. More specifically, the master file should provide for information regarding the organiza-tional structure, a description of the business activities, intangibles, financial activities within the group, the financial and tax position of the MNE group and a list of key agreements, intangibles and transactions.

The State Secretary of Finance has provided for detailed implementation rules regarding the form and content of the master file.7 These implementation rules are largely based on the OECD’s template.8

3.2. Local File

According to article 29g, section 2, CITA, the local file must contain information deemed relevant for a transfer pricing analysis in respect of the intercompany transactions of the local entity. This file should show that the group entity acts with its affiliates on an arm’s-length basis, in ac-cordance with article 8b CITA. Furthermore, the local file should contain information that substantiates a business-like profit allocation to its permanent establishments.


the NetherlANdS

The State Secretary of Finance has provided for detailed implementation rules regarding the form and content of the local file.9 These implementation rules are largely based on the OECD’s template.10

The Dutch company has to keep the master and local files in its administration and is only required to share these with the Dutch tax authorities at the latter’s request. These files must be prepared and updated by the submis-sion deadline for the corporate income tax returns for the relevant fiscal year, starting in 2016.

3.3 Penalties in the Event of Noncompliance with the Additional Transfer Pricing Documentation RequirementsThe Dutch Legislation does not contain specific pen-alties for noncompliance with the additional transfer pricing documentation requirements. However, on the basis of article 8b, section 3, CITA, the transfer pricing documentation of a company should be included in the company records, encompassing the master file and the local file. If such company records are not maintained in accordance with the law, liability to pay a penalty of EUR 8,100 and/or to a term of imprisonment of not more than six months as prescribed by article 68 GTA may ensue. Article 69, section 1, GTA provides that in the event of intentional failure to maintain such records or if such failure is due to gross negligence, and this results in underpaid taxes, liability to pay a penalty of EUR 20,250 and/or a term of imprisonment of not more than four years may ensue.

4. ConclusionMNEs with Dutch companies may be confronted with the necessity to comply with the Dutch CBC reporting provisions and transfer pricing documentation require-ments for the fiscal year 2016. This is the case if the Dutch

company is regarded as the “surrogate parent company” (paragraph 2.3). For example, a Dutch intermediary holding company of a multinational enterprise, whose ultimate parent company is a resident of a jurisdiction that has not (yet) implemented CBC reporting (condition 2.3 (A)), would be required to act as a surrogate parent company. As a surrogate parent company, the Dutch intermediary company is obliged to file a CBC report on the MNE group as a whole, which requires informa-tion the holding company has to obtain from the group. Furthermore, neither the OECD model legislation nor the Dutch Legislation on CBC reporting provides for transitional arrangements. Such arrangement would perhaps be expected in cases where, for example, the jurisdiction of the ultimate parent company intends to implement CBC reporting, but not as of 2016 (as is the case, for example, with the United States, based on the latest proposals).

The additional transfer pricing documentation require-ments should be considered complementary to article 8b, CITA, which already requires companies to keep documentation on transfer pricing aspects of intra-group transactions. The Dutch government has chosen to exempt small and medium-sized enterprises from these additional requirements if the group’s consolidated gross revenue does not exceed EUR 50 million.

CBC reporting and the additional transfer pricing documentation requirements should make it easier for tax administrations to identify whether MNEs have engaged in transfer pricing and other practices that have the effect of artificially shifting profits to favourable tax jurisdictions. In particular, the CBC report, which has to be filed with the Dutch tax authorities and will be exchanged with the relevant foreign tax authorities, will provide more insight into the tax conduct of MNEs. The Dutch Legislation implementing CBC reporting and additional transfer pricing documentation requirements can be considered a significant change from the previous Dutch reporting and documentation requirements.

EndnotEs

1 oeCd-G20 Base erosion and Profit Shifting Proj-ect, explanatory Statement, 2015 Final reports.

2 oeCd-G20 Base erosion and Profit Shifting Project, explanatory Statement, 2015 Final reports, 17.

3 oeCd-G20 Base erosion and Profit Shifting Project, transfer Pricing documentation and Country-by-Country reporting, Action 13: 2015 Final report, 9.

4 Parliamentary Papers ii 2015/16, 34 305, No. 2.

5 oeCd-G20 Base erosion and Profit Shifting Project, transfer Pricing documentation and Country-by-Country reporting, Action 13: 2015 Final report, 33.

6 oeCd-G20 Base erosion and Profit Shifting Project, transfer Pricing documentation and Country-by-Country reporting, Action 13: 2015 Final report, 29–30.

7 decree State Secretary of Finance december 30, 2015 dB2015/462, 4-5.


9 decree State Secretary of Finance december 30, 2015 dB2015/462, 7-8.



The IRS Issues New Code Sec. 956 Regulations*

By John D. McDonald, Stewart R. Lipeles and Samuel Pollack

I. IntroductionCode Sec. 956 applies when a controlled foreign corporation (CFC) invests its earnings in certain types of property (“U.S. property”). If Code Sec. 956 applies, the U.S. shareholders of the CFC may be required to recognize an income in-clusion. The legislative history of Code Sec. 956 explains that Congress enacted the statute because it viewed having untaxed earnings of a CFC invested in the United States as substantially the equivalent of a CFC paying a dividend to the shareholder.1 This policy is especially apparent with respect to CFC loans to U.S. parent entities, where, but for the provisions of Code Sec. 956, the U.S. parent would have relatively unfettered use of its CFC’s cash earnings, without the need to distribute said earnings. In the context of CFC loans, the legislative history goes further to explain that “if the facts indicate that the controlled foreign subsidiary facilitated a loan to, or borrowing by, a U.S. shareholder, the controlled foreign corporation is considered to have made a loan to (or acquired the obligation of ) the U.S. shareholder.”2 The most straightforward way for a CFC to “facilitate” a U.S. parent’s borrowing is for the CFC to guarantee such borrowing. The con-cern described in the legislative history has implications that apply beyond the guarantee context, however. The outer boundaries of the legislative history and how Code Sec. 956 may apply to partnerships have been unanswered questions for some time. Three key questions are highlighted below.

II. Issues and Examples

A. Issue 1When one CFC facilitates a different CFC’s investment in U.S. property, may the latter’s investment in U.S. property be “imputed” to the former? Historically, prior temporary regulations provided that “[A] controlled foreign corporation will be considered to hold indirectly … at the discretion of the District Director, investments in U.S. property acquired by any other foreign corporation that is controlled by the controlled foreign corporation, if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt)

saMuEl Pollack is an Associate in the Global tax Practice Group at Baker & mcKenzie, llP, in Chicago.

stEwart r. liPElEs is a Partner in the Palo Alto office of Baker & mcKenzie, llP.

JoHn d. Mcdonald is a Partner in the Chicago office of Baker & mcKenzie, llP. Baker & mcKenzie llP is a member of Baker & mcKenzie international, a Swiss Verein.


such other foreign corporation is to avoid the applica-tion of section 956 with respect to the controlled foreign corporation” (the “Section 956 Anti-Abuse Rule”).3 The temporary regulations applied whenever a CFC with significant amounts of earnings and profits (E&P) loaned to a CFC with no E&P with the objective of enabling the latter CFC to acquire U.S. property (e.g., a loan to the CFC’s U.S. parent). What was unclear was whether the rule would also apply when both CFCs had significant E&P but the latter CFC had E&P with a higher effective tax rate than the former.

Example 1. USCO is a U.S. corporation that wholly owns both CFC1, a Country X corporation, and CFC2, a Country Y corporation. Country X does not impose a corporate income tax, while Country Y imposes a 33.3-percent corporate income tax. Both CFC1 and CFC2 have E&P of $100. CFC1’s foreign taxes are zero and CFC2 has $50 of foreign taxes in its Code Sec. 902 indirect foreign tax credit pool. CFC1 loans $100 to CFC2, and CFC2 loans the same amount to USCO. USCO will report a $150 deemed dividend from CFC2 ($100 under Code Sec. 951(a)(1)(A) and $50 under Code Sec. 78). Yet, the foreign tax credits resulting from the distribution under Code Sec. 902 may substantially reduce the resulting tax liability. See Diagram 1.

Assuming that in Example 1, CFC1’s loan to CFC2 would be treated as a “funding” of CFC2, the taxpayer would still have the opportunity to argue that its purpose was not “to avoid the application of section 956 with respect to the controlled foreign corporation.” After all, there was no avoidance of Code Sec. 956. Whether CFC1 or CFC2 made the loan to USCO, USCO would have had a Code Sec. 951(a)(1)(A) inclusion of $100. Indeed, the tax

benefit illustrated in Example 1 is from Code Sec. 902 tax credits, not from avoiding Code Sec. 956. On the other hand, arguably, Code Sec. 956 was avoided with respect to CFC1 and, therefore, USCO avoided the “application of section 956 with respect to the controlled foreign cor-poration.” Resolution of the issue depends on whether the anti-abuse rule is designed to prevent the avoidance of Code Sec. 956, generally, or whether it is designed to prevent avoidance of Code Sec. 956 with respect to specific CFCs that “fund” other CFCs.

B. Issue 2

When should a CFC’s indirect ownership of U.S. prop-erty through a partnership be imputed to the CFC? To an extent, this issue was addressed in Rev. Rul. 90-112.4 The ruling discussed whether a CFC that is a partner in a partnership (whether U.S. or foreign) that owns U.S. property should be treated as owning a share of the part-nership’s U.S. property. The ruling discussed whether the partnership should be treated as a separate and distinct “entity” or whether the partnership is treated merely as an “aggregate” of all of the properties that it owns (the “Entity/Aggregate Question”). The ruling concluded that, in this case, the aggregate approach was most ap-propriate. Thus, a CFC that was a 25-percent owner in a partnership was treated as owning 25 percent of the U.S. property held by the partnership. In 2002, the Treasury finalized regulations confirming the IRS’s approach in Rev. Rul. 90-112. The final regulations provide under Reg. §1.956-2(a)(3):

For purposes of section 956, if a controlled foreign corporation is a partner in a partnership that owns property that would be United States property, within the meaning of paragraph (a)(1) of this section, if

owned directly by the controlled foreign corporation, the con-trolled foreign corporation will be treated as holding an interest in the property equal to its interest in the partnership and such inter-est will be treated as an interest in United States property.

The most significant issue with the regulations was that they failed to indicate whether special alloca-tions of partnership items (e.g., income, gain and loss) with respect to a partnership’s U.S. property may

diagraM 1.

USCO

CFC2CFC1

$100 Loan

$100 Loan

E&P: $100FTC: $0

E&P: $100FTC: $50

the irS iSSueS NeW Code SeC. 956 reGulAtioNS


be a reason to deviate from the “interest in the partnership” standard. The IRS did issue a much discussed letter ruling suggesting that special allocations of partnership items derived from U.S. property are taken into account.5 The issue is illustrated in Example 2. There were two further issues with the regulations. First, they provided no guid-ance with respect to the method for calculating a CFC’s “interest in the partnership,” as illustrated in Example 3. Second, certain arguably abusive transactions were not addressed, as illustrated in Example 4. For each of the examples, CFC is the wholly owned foreign subsidiary of USCO, a U.S. corporation, and CFC is a partner in a foreign partnership, FPP.

Example 2. FPP holds no U.S. property other than a $100 loan to USCO, and income, gain and loss with respect to the loan are specially allocated to FPP’s non-CFC partners. In this circumstance, it is unclear whether (1) a portion of the loan receivable is allocable to CFC based on its interest in FPP, or (2) no portion of the loan receivable is allocable to CFC because the income, gain or loss from the loan is specially allocated away from CFC.

Example 3. Under FPP’s partnership agreement, CFC is entitled to 100 percent of all partnership profits until it receives a preferred return of 10 percent on its investment of $100. Thereafter, FPP is entitled to 30 percent of the profits of FPP. CFC is also entitled to a $100 preference on liquidation. In this scenario, Reg. §1.956-2(a)(3) provides no guidance to determine CFC’s “interest in the partnership.”

Example 4. CFC’s interest in FPP is a uniform 51 percent. CFC contributes $100 to FPP, and FPP then lends $100 to USCO. Under Reg. §1.956-2(a)(3), with respect to FPP’s loan to USCO, CFC’s invest-ment in U.S. property is only $51, its proportionate interest in USCO’s obligation to FPP. Nevertheless, USCO has the benefit of a $100 loan from CFC’s earnings in much the same way that it would have had that benefit had CFC loaned the money directly to USCO. See Diagram 2.

All of the foregoing examples raise questions about how to measure CFC’s ownership of the U.S. property held by the partnership. Should taxpayers be able to use special allocations to avoid any investment as in Example 2? Should they be able to effectively loan money through a partnership to their related U.S. par-ent through a partnership without being considered

to own the entire loan, as in Example 4? What happens when the partnership has a more complex income alloca-tion scheme, as in Example 3?

C. Issue 3

When a CFC makes a loan to a foreign partnership owned by related or unrelated U.S. persons, should the partner-ship’s liability be treated a liability of its partners?

Example 5. USCO wholly owns CFC. USCO is also a partner in a foreign partnership, FPP. CFC loans $100 to FPP, and FPP distributes the proceeds to USCO. See Diagram 3.

Here, it is important that FPP is a foreign partnership. If FPP were a domestic partnership, the result would be clear. Domestic partnerships are “U.S. persons”6; therefore, CFC’s loan to FPP would itself have been an investment in U.S. property. In Example 5, because FPP is a foreign partnership, CFC would only be treated as having made an investment in U.S. property to the extent that we look through FPP and treat CFC’s loan to FPP as a loan to USCO.

In the instant circumstance, the question is whether a partnership is viewed as the debtor for its liabilities or whether the partnership is an aggregate of, generally, nonrecourse liabilities owed by its partners. Under an ag-gregate theory, in Example 5, a portion of CFC’s loan to FPP should be treated as a loan to USCO and, thus, an investment in U.S. property.

The issues described above are the subjects of new tem-porary and proposed regulations.

diagraM 2.

USCO

CFC

FPP

OtherPartners

$100 Loan

$100 Loan

51% 49%


III. New Temporary and Proposed Regulations

On September 2, 2015, the Treasury and the IRS released new tempo-rary and new proposed regulations for Code Sec. 956 (separately, the “Temporary Regulations” and the “Proposed Regulations” and together, the “Regulations”).7 The Temporary Regulations modify the existing text of the Section 956 Anti-Abuse Rule, and they add a similar rule that applies when a CFC creates, organizes or funds a partnership to acquire U.S. property. The Temporary Regulations also provide a separate anti-abuse rule that applies when a CFC makes a loan to a partnership and that loan enables the partnership to make a distribution to the CFC’s U.S. parent. The Temporary Regulations’ modification to the Section 956 Anti-Abuse Rule and their two new anti-abuse rules relating to partnerships were effective September 2, 2015. Thus, taxpayers with foreign partnerships in their structure should review these rules now to ensure they do not have any arrangements that would run afoul of the modified anti-abuse rule.

The Proposed Regulations provide two partnership rules that both generally apply the aggregate concept for partnerships in the Code Sec. 956 context. One rule provides the method for attributing the U.S. property of a partnership to a CFC partner, and a second rule pro-vides the method for attributing the liabilities of a foreign partnership to its U.S. partners. The Proposed Regulations will not come into effect until they are finalized.8

IV. Modifications to the Anti-Abuse Rule

The Temporary Regulations modify the existing language of the Section 956 Anti-Abuse Rule. First, the Temporary Regulations remove the requirement that the District Director exercise her authority to execute the rule.9 The preamble to the Temporary Regulations indicates that this requirement was removed because the rule “should apply without requiring the IRS to exercise its discre-tion.”10 A possible alternative explanation may be that by act of Congress, the IRS has not had district directors in nearly 15 years, and regulations granting authority to

defunct IRS offices have been troublesome to the IRS in the recent past.11

The Temporary Regulations also include language to in-dicate that “funding” means funding “by any means.”12 No explanation is provided in the preamble. This unexplained expansion of the term “funding” could raise concerns over whether the rule now captures dividend distributions. Most practitioners would likely agree that dividends are not considered a “funding” because the term “funding” had been included in the Section 956 Anti-Abuse Rule to target transactions that separate assets from the E&P arising in connection with those assets.13 In a dividend distribution, by definition, assets representing E&P are moved with E&P. Moreover, there was always a strong argument that although the CFC receiving the dividend did not directly possess the assets it received in the distri-bution, it indirectly owned the assets. Put another way, the dividend merely converted indirect ownership into direct ownership and did not provide the CFC with assets that the CFC was not entitled to. In our view, the term “funding” should still not be read to include dividends.

The more important change in the Temporary Regula-tions is the addition of an Example,14 which clarifies that even if a funding results in a Code Sec. 956 inclusion, the funding still can be treated as having been executed for the principal purpose of avoiding Code Sec. 956.

In our Example 1, above, CFC1 had E&P of $100 and no foreign taxes. CFC2 had $100 of E&P and $50 of foreign taxes. CFC1 loaned $100 to CFC2, and CFC2 on-loaned the funds to USCO. The new Example in the Temporary Regulations now indicates that in such a trans-action, there is a principal purpose to avoid the application of Code Sec. 956 to CFC1 even though the funding did not have the effect of reducing the Code Sec. 956 inclusion.

diagraM 3.

USCO

CFC

$100 Loan

$100Distribution

X% Y%

FPP

OtherPartners



It is notable to mention that in our Example 1, if instead of lending the money to USCO, CFC2 distributed the money to USCO, there is no question that Code Sec. 956 would not apply. See Diagram 4. Granted, the option to make an actual distribution is not always available. Fur-thermore, in certain instances, a Code Sec. 956 inclusion would be preferable to an actual distribution (for example, a Code Sec. 956 inclusion does not give rise to source-country dividend withholding tax).

Lastly, the Temporary Regulations address certain partnership-related issues. Example 4 involved a CFC contributing funds to a partnership that loaned them to the CFC’s related U.S. parent. Example 5 illustrates how U.S. taxpayers could cause their wholly owned CFCs to loan money to partnerships owned, at least in part, by them. Those partnerships could then make a distribu-tion to the taxpayer, effectively repatriating cash to the U.S. partner.

The Proposed Regulations, discussed below, address these issues holistically by providing rules for determin-ing what portion of the partnership’s assets should be imputed to a CFC and what portion of a partnership’s liabilities owing to a CFC should be considered attribut-able to U.S. partners related to the CFC. As a stop-gap measure, while the Proposed Regulations are being vetted and commented on, however, the Temporary Regulations amend the anti-abuse rule effective September 2, 2015, to address the fact patterns in Example 4 and Example 5. We address the Temporary Regulations and the Proposed Regulations below.

V. Guidance on Property Held by a CFC Through a Partnership

The Temporary Regulations also add a new rule to the Sec-tion 956 Anti-Abuse Rule that applies when a CFC forms, organizes or funds a partnership to avoid the application of Code Sec. 956 to the partnership’s investment in U.S. property. In this case, the partnership’s entire investment in U.S. property is attributed to the CFC. The Proposed Regulations provide a broader rule that applies even if there is no abuse present. The Proposed Regulations provide rules for determining what portion of a partnership’s U.S. property should be attributed to a CFC owner under Reg. §1.956-2(a)(3).

A. The Temporary Regulations’ Anti-Abuse Rule

The Temporary Regulations provide that15:

Property acquired by a partnership that is controlled by the controlled foreign corporation if the property would be United States property if held directly by the controlled foreign corporation, and a principal pur-pose of creating, organizing, or funding by any means (including through capital contributions or debt) the partnership is to avoid the application of section 956 with respect to the controlled foreign corporation.

…

[A] controlled foreign corporation controls a … partnership if the controlled foreign corporation and the … partnership are related within the meaning of section 267(b) or section 707(b).

One of the issues identified in Issue 2 was that a CFC partner could make indirect loans to its U.S. parent by funding loans through its controlled partnership. Under Reg. §1.956-2(a)(3), by itself, the CFC’s Code Sec. 956 inclusion would be limited by the CFC’s interest in the partnership even though the U.S. parent received a benefit in the full amount of the loan. The Temporary Regulations alter this result.

In Example 3, CFC, a 51-percent partner in FPP, contributed $100 to FPP so that FPP would on-loan the $100 to USCO. Under the Temporary Regulations, CFC would be treated as being in control of FPP and, therefore, CFC’s funding of the loan to USCO would cause CFC to be treated as the owner of the entire loan receivable, resulting in a $100 investment in U.S. prop-erty for CFC.

diagraM 4.

USCO

CFC2CFC1

$100 Distribution

$100 Loan

E&P: $100FTC: $0

E&P: $100FTC: $50


This rule only applies when the partnership is “con-trolled” by the CFC within the meaning of Code Sec. 707(b). Code Sec. 707(b) determines control of a partnership based on the capital or profits interests of the partners. For example, if CFC held all of the voting interests of FPP and 50 percent or less of the economic interests in FPP, the Temporary Regulations would not apply. It is unclear why the IRS did not choose a standard focused more on voting control, considering that voting control over FPP will determine whether or not it ac-cepts a loan from CFC and whether or not it on-lends the proceeds to USCO.

B. Proposed Regulations Provide General Rule for Imputing U.S. Property Held by a Partnership to a CFC Partner Even When There Is No AbuseThe Proposed Regulations provide new rules governing the method for allocating a partnership’s U.S. property to its CFC partners, when the anti-abuse rule does not apply.16 The Proposed Regulations establish a “General Rule” and a “Special Allocation Rule.” Under the General Rule, a CFC partner in a partnership is treated as holding its attributable share of any property held by the partner-ship. A partner’s attributable share of the partnership’s property is determined in accordance with the partner’s “liquidation value percentage” (LVP). A partner’s LVP is determined by hypothesizing a constructive liquidation. Such constructive liquidation is deemed to occur imme-diately after the partnership’s most recent “revaluation event” (e.g., a non-de minimis contribution, a partial/complete liquidation of a partner’s interest and other specified events that impact the relative interest of the partners).17 If there has been no revaluation event, the constructive liquidation is deemed to occur immediately after the formation of the partnership.

In the constructive liquidation, the partnership is treated as:1. selling all of its assets for cash equal to their fair market

values of such assets;2. satisfying all of its liabilities (i.e., those described in

Reg. §1.752-1) in a fully taxable transaction;3. paying an unrelated third party to assume all of its

nonliability obligations (i.e., its Reg. §1.752-7 obliga-tions); and then

4. liquidating.A partner’s LVP is the ratio (expressed as a percentage)

of the liquidation value of the partner’s interest in the partnership divided by the aggregate liquidation value of all of the partners’ interests in the partnership.

The Special Allocation Rule modifies the General Rule to accommodate for the existence of special allocations:

… if a partnership agreement provides for the allo-cation of income (or, where appropriate, gain) from partnership property to a partner that differs from the partner’s liquidation value percentage in a particular taxable year (a special allocation), then the partner’s attributable share of that property is determined solely by reference to the partner’s special allocation with respect to the property, provided the special alloca-tion does not have a principal purpose of avoiding the purposes of section 956.

The Special Allocation Rule states that it applies to special allocations of gain “where appropriate,” without providing an explanation. The Proposed Regulations pro-vide an Example that sheds some light, illustrating that the “where appropriate” determination is made based on the type of return that is expected to be generated from the property subject to the special allocation.18 In the Example, the partnership’s “property is anticipated to appreciate in value but generate relatively little income”; therefore, “the partners’ attributable shares of the [partnership’s] property are determined in accordance with the special allocation of gain.”

In Example 2, FPP held a $100 loan receivable owing from USCO, but income, gain and loss with respect to the loan were specially allocated to FPP’s non-CFC partners. Reg. §1.956-2(a)(3) left open the possibility that FPP’s CFC partner could still be treated as owning a share of the loan receivable. The Special Allocation Rule would clarify that CFC would not be considered to own the loan receivable, unless the special allocations with respect to the loan had a principal purpose of avoiding the purposes of Code Sec. 956. This is generally consistent with the IRS’s conclusion in LTR 200832024.

One significant omission is the failure of the regulations to address precisely how the Special Allocation Rule and the General Rule would apply at the same time to the same partnership. In Example 2, it is possible that a reviewing court would simply conclude that the loan, and income or gain associated with the loan, would be excluded from the partnership altogether and only the remaining assets of the partnership would be dealt with under the General Rule.

But more complex fact patterns raise more challenging issues. Recall that in Example 3, CFC was entitled to (1) 100 percent of FPP’s profits until it received a preferred return of 10 percent on its investment of $100; (2) 30 percent of the profits thereafter; and (3) a liquidation preference of $100 on its equity. Let us further assume that



FPP had no liabilities and no nonliability obligations and that the combined equity of all partners in FPP was $200 ($100 provided by CFC and $100 by the other partners).

If the assets of FPP had a fair market value of $300, in a constructive liquidation, CFC would receive $137 resulting in a 45.67 percent LVP based on the following procedure. Specifically, FPP would have sold its assets for $300. Because FPP had no liabilities or nonliability obli-gations, all $300 would be distributed to FPP’s partners. CFC would receive $100 for its liquidation preference and the remaining $100 of equity would go to FPP’s other partners, totaling $200 distributed on equity. There would be $100 of profit remaining, with $10 paid to CFC’s for its preferred return (10 percent of $100) and $27 (30 percent of $90) paid to CFC from the residual profits. The distribution to CFC, $137, would then be divided by the distributions to all partners, $300, to arrive at a 45.67 percent LVP for CFC.

This LVP is different from the 30-percent allocation of profits. The question is whether the Special Allocation Rule should apply. The Special Allocation Rule would presumably not apply so long as the 30-percent alloca-tion was not with respect to unique items of partnership property. This is not entirely clear from the regulations, but one could assume based on the examples that the Special Allocation Rule is intended to apply only when there are allocations of income or gain from specific items of partnership property.

If Example 3 were changed, and the 30-percent alloca-tion was directly related to a specific item of property, the Special Allocation Rule would presumably apply. Yet, the regulations do not tell us what we then do with that asset and how we apply the General Rule to the remain-ing partnership assets. The examples dodge the issue by assuming that the special allocation relates to the U.S. property owned by the partnership. Given that the only reason the taxpayer needs to embark on this analysis is to figure out the CFC’s share of that property, there is no need to go further. Yet, this need not be the case. The special allocation could relate to one item of U.S. property and not another. It could also apply to property that is not U.S. property. Either way, a determination has to be made how the General Rule applies to the remaining property that is not subject to the Special Allocation Rule.

VI. Guidance on Loans to a Foreign Partnership Owned by U.S. Persons

The Temporary and Proposed Regulations discussed above apply the aggregate theory to partnerships to treat

the assets of the partnership as though they were owned by the partnership’s CFC owner. The Temporary and Proposed Regulations also provide rules further apply-ing the aggregate theory to treat the liabilities of foreign partnerships as the liabilities of their owners, causing CFC loans to foreign partnership to be treated as loans to the partnership’s U.S. partners.

A. The Temporary Regulations’ Anti-Abuse Rule

The Temporary Regulations provide that an obligation of a foreign partnership held by (or treated as held by) a CFC is treated as an obligation of a partner, when19:1. the partnership makes a distribution to the partner;2. the distribution to the partner would not have been

made but for the CFC’s funding the obligation (a “Funded Distribution”); and

3. the partner is “related” to the CFC (under Code Sec. 954(d)(3)).

The amount of the obligation treated as a direct obliga-tion of such partner is equal to the lesser of:1. the amount of the Funded Distribution; and2. the amount of the obligation.

In Example 4, CFC made a loan to FPP, FPP made a distribution to USCO and USCO was related to CFC. Therefore, if CFC’s loan was the “but-for” cause of the distribution to USCO, the Temporary Regulations will treat CFC as having lent $100 directly to USCO.

Here, the Temporary Regulations require taxpayers to determine what constitutes a “but-for” cause of the distribu-tion. For example, add to the facts of Example 4 that FPP has made annual $100 distributions to USCO every year since FPP was formed. In the current year, FPP has sufficient operating profits to make a $100 distribution to USCO, but FPP would like to reinvest its operating profits in its busi-ness. For this reason, FPP borrows $100 from CFC so that it can invest an amount equal to its total profits in its business while at the same time making its annual $100 distribution to USCO. Is the loan the “but-for” cause of the distribu-tion? In other words, if FPP can establish that it would have distributed its operating profits and not reinvested them had CFC not made the $100 loan to FPP, would that be a necessary or even a sufficient condition to show that the loan was not the “but-for” cause of the distribution?

B. General Rule for Imputing a Foreign Partnership’s Liabilities to Its Partners

The Proposed Regulations address the same issue more holistically and treat some of FPP’s liabilities as liabilities


of USCO regardless of whether the partnership distributes any cash to its U.S. partners or not. The Proposed Regula-tions provide that generally20:

[A]n obligation of a foreign partnership is treated as a separate obligation of each of the partners in the partnership to the extent of each partner's share of the obligation. A partner's share of the partnership's obligation is determined in accordance with the partner's interest in partnership profits. The partner's interest in partnership profits is determined by taking into account all facts and circumstances relating to the economic arrangement of the partners.

An exception applies, however, when the partner is not a CFC nor a person related to a CFC (under Code Sec. 954(d)(3)) to which Code Sec. 956 would have applied by virtue of such attribution.21 In such case, the obligations of a foreign partnership are not attributed to a partner.

In Example 5, USCO is a partner in FPP. If USCO holds more than 50 percent of the beneficial interest in FPP, by value, a share of FPP’s obligations will be treated as obligations of USCO. Otherwise, the Partnership Li-ability General Rule will not apply. So, for example, if USCO owns 51 percent of FPP, $51 of CFC’s loan to FPP will be treated as a liability of USCO, resulting in a $51 investment in U.S. property.

It is not clear how to apply the Proposed Regulations when partners share different partnership items differently. These regulations do not incorporate the LVP calculation of the Proposed Regulations discussed above.22 Instead,

these rules use an amount that tracks with the method applied for allocating partnership excess nonrecourse liabilities under Code Sec. 752, as indicated in the pre-amble to the Proposed Regulations.23 Determining a “partner’s share of the partnership’s profits” under Code Sec. 752 has been a point of confusion for the IRS and for taxpayers in the recent past, when the IRS released proposed regulations under Code Sec. 752.24 Confusing the issue further, the recently proposed Code Sec. 752 regulations use a calculation that is materially the same as the LVP method to determine a “partner’s share of the partnership’s profits.”25 If the IRS’s view is that “partner’s share of the partnership’s profits” and LVP are the same in the context of Code Sec. 752, it is curious why the IRS explicitly distinguishes the two in the context of Code Sec. 956. To an extent, the IRS appears to recognize the lack of clarity, soliciting comments “on whether the liquidation value percentage method or another method would be a more appropriate basis for determining a partner’s share of a foreign partnership’s obligation.”26

VII. ConclusionIn the new Regulations, the Treasury and the IRS attempt to address difficult and complex issues that have been pervasive since Congress enacted Code Sec. 956. The IRS should be commended for attempting to make headway in a difficult area. We envision that the determination of a CFC’s interest in a partnership’s assets and the alloca-tion of a partnership’s liabilities to its U.S. partners will provide very difficult in real-world fact patterns, however.

EndnotEs

* this article is reprinted from taxes, Jan. 2016, at 7.

1 h.r. rep. No. 87-1447, 2d Sess., at 58 (1962); S. rep. No. 94-938, at 226 (1976).

2 h.r. rep No. 94-658, at 217 (1976); S. rep. No. 94-938, at 227 (1976).

3 temporary reg. §1.956-1t(b)(4)(i)(B).4 rev. rul. 90-112, 1990-2 CB 186.5 ltr 200832024 (dec. 11, 2007).6 See Code Secs. 957(c); 7701(a)(30)(B). the

new proposed regulations also confirm this conclusion stating “For purposes of section 956, an obligation of a domestic partnership is an obligation of a united States person.” Proposed reg. §1.956-4(e).

7 t.d. 9773, irB 2015-41, 494 (Sept. 1, 2015); Notice of Proposed rulemaking, Fr Vol. 80, No. 170, p. 53058 (Sept. 2, 2015).

8 however, except for in the circumstances described below, at the time the Proposed regulations go into effect, they will apply to any property acquired as of September 1, 2015.

9 temporary reg. §1.956-1t(b)(4)(i)(B).

10 t.d. 9733, irB 2015-41, 494 (Sept. 2, 2015); see also t.d. 9477, irB 2010-6, 385 (dec. 30, 2009) (offering the same explanation for the removal of this requirement in the context of the related anti-abuse rule applicable under Code Sec. 304).

11 the internal revenue Service reform and re-structuring Act of 1998 set out procedures for the reorganization of the irS, which included the elimination of the office of district director. Since the restructuring, the irS has litigated a number of cases where the taxpayer attempted to use the irS’s failure to update references to offices eliminated in the restructuring to chal-lenge the irS’s authority to execute such regu-lations. most notably, taxpayers have unsuc-cessfully argued that tax assessments should all be void because under reg. §301.6201-1, the authority to make assessments is vested in the district director. See S. Grunsted, 136 tC 455, dec. 58,621; T.F. Zdun, dC-or, 2011-1 ustc ¶50,229. Nevertheless, the irS has also lost cases owning to its failure to update rules

to respond to the restructuring. See Living Word Christian Ctr., dC-mN, 2009-1 ustc ¶50,199; Glasgow Realty, LLC v. Withington, dC-mo, 2005-1 ustc ¶50,124, 345 FSupp2d 1025.

12 temporary reg. §1.956-1t(b)(4)(i)(B).13 See t.d. 8209 (June 14, 1988) (explaining that

the term “funding” was added to the original rule to correct a flaw that allowed taxpayers to circumvent Code Sec. 956 through the, “trans-fer [of] assets representing earnings and profits to another CFC and [by] having the transferee invest those earnings in u.S. property”); see also FSA 1995-1 (July 11, 1995).

14 temporary reg. §1.956-1t(b)(4).15 temporary reg. §1.956-1t(b)(4)(i)(C).16 Proposed reg. §1.956-4(b).17 reg. §§1.704-1(b)(2)(iv)(f)(5) and 1.704-1(b)(2)

(iv)(s)(1) describe what constitutes a revalua-tion event.

18 Proposed reg. §1.956-4(b)(3), ex. 3.19 temporary reg. §1.956-1t(b)(5).20 Proposed reg. §1.956-4(c)(1).


Continued on page 37

January–February 2016 17© 2016 D.S. MILLER AND J. SCHWARTz

New 871(m) Regulations Finalize Dividend-Equivalent Payment Withholding Rules for Equity Derivatives*

By David S. Miller and Jason Schwartz

I. Introduction

On September 17, 2015, the IRS and the Treasury issued final, temporary and proposed regulations under Section 871(m) of the Internal Revenue Code (the “Code”) (collectively, the “new regulations”) that provide the rules for withhold-ing on “dividend-equivalent payments” on derivatives that reference U.S. equity securities.1 In general, the rules narrow the class of derivatives that would have been subject to withholding under the proposed regulations issued in 2013 (the “2013 proposed regulations”). For example, under the new regulations, a “simple contract” is not subject to withholding unless its delta is 0.80 or more, whereas under the 2013 proposed regulations, withholding would have been imposed if the delta was at least 0.70.2 However, the new regulations still require with-holding on “price-return-only” derivatives that do not provide for payments that reference dividends.3

In addition, the new regulations delay the effective date that would have applied under the 2013 proposed regulations. Under the new regulations, withholding is imposed on equity derivatives issued after 2016.4 The 2013 proposed regulations generally would have appinlied to all payments made on an equity derivative after 2015, regardless of when the derivative was entered into.

Some of the most important aspects of the new regulations are:Higher delta threshold of 0.80. As mentioned above, the new regulations increase the delta threshold for a “simple” contract to determine whether an equity derivative is subject to withholding to 0.80, from 0.70 in the 2013 proposed regulations.5 A simple contract is a derivative for which payments are calculated by reference to a single, fixed number of shares that can be ascertained when the derivative is issued and that has a single maturity or exercise date with respect to which all amounts (other than any upfront pay-ment or any periodic prepayments) are required to be calculated with respect to the underlying security.6

david s. MillEr is a Partner in the New York office of Cadwalader, Wickersham & taft.

Jason scHwartz is an Associate in the Washington, d.C., office of Cad-walader, Wickersham & taft.


Special rules for complex contracts. The new regulations do not apply the 0.80 delta test to “complex contracts” (i.e., all derivatives other than simple contracts). Instead, the new regulations adopt a “substantial equivalence” test that compares the change in value of a complex contract with the change in value of the shares of the equity security that would be held to hedge the derivative over an increase or decrease in the price of the equity security by one standard deviation.7 If the proportionate difference between (1) the change in value of the complex contract and the change in value of its hedge is no greater than (2) the change in value of a benchmark simple contract with respect to the same shares with a delta of 0.80 and the change in value of its hedge, then the complex contract is substantially equivalent to the underly-ing security and dividend-equivalent payments with respect to it are subject to withholding.8

Day-one delta test. The new regulations test a de-rivative’s delta (or substantial equivalence) at initial issuance.9 By contrast, the 2013 proposed regula-tions generally tested a derivative’s delta each time a foreigner acquired the derivative and each time a dividend was paid or (in the case of short-term de-rivatives) the derivative was disposed of. The day-one delta test makes it much easier for taxpayers to identify derivatives subject to withholding.Convertible debt instruments. Although the new regula-tions apply to convertible debt instruments (as did the 2013 proposed regulations), the combination of the increased 0.80 delta threshold and the day-one delta test will have the effect of exempting most traditional convertible debt instruments because they generally have deltas lower than 0.80 upon issuance.Withholding on price-return-only derivatives. As men-tioned above, the new regulations retain the rule in the 2013 proposed regulations that requires withholding on an equity derivative that satisfies the 0.80 delta test or the substantial equivalence test even if the derivative does not provide for payments based on dividends, on the theory that dividend payments are implicit even in a contract that does not provide for them.10 As discussed below, we believe that this rule continues to present statutory authority and tax treaty issues.Simplified rules for determining the amount of a dividend-equivalent payment subject to withholding. Under the 2013 proposed regulations, the amount of the dividend-equivalent payment subject to with-holding was equal to the per-share dividend amount with respect to the underlying security, multiplied by the number of shares of the underlying security

referenced in the contract, multiplied by the delta at the time the dividend equivalent was determined. De-termining the delta each time the dividend equivalent is determined would have been particularly difficult as an administrative matter. The new regulations require delta to be determined only at the time a derivative is issued.11

Withholding on short-term options. The new regulations impose withholding on an equity option with a delta of 0.80 or more, even if the option has a term of one year or less and is not exercised. The 2013 proposed regulations did not require withholding on lapsed short-term options.Presumptions for combined transactions. The 2013 proposed regulations required a withholding agent to withhold on an equity derivative that failed the delta test if, after using “reasonable diligence,” the with-holding agent concluded that the derivative had been entered into “in connection with” another derivative and, when combined, the derivatives satisfied the delta test. The new regulations retain this rule,12 but add two helpful presumptions for short-party brokers. First, a short-party broker may presume that transactions are not entered into in connection with each other if the long party holds the transactions in separate accounts, so long as the broker does not have actual knowledge that the long party used the separate accounts to avoid Code Sec. 871(m) or that the transactions were entered into in connection with each other.13 Second, a short-party broker may presume that transactions are not entered into in connection with each other if they are entered into at least two business days apart, so long as the broker does not have actual knowledge that the transactions were entered into in connection with each other.14 These presumptions do not apply to long parties15; thus, all transactions that are entered into in connection with each other are combined for purposes of determining whether a long party is sub-ject to tax under Code Sec. 871(m), but if the short party benefits from a presumption, this tax may not be collected through withholding.Qualified indices. Derivatives that reference a “quali-fied index” are not subject to withholding under Code Sec. 871(m).16 The new regulations test whether an index is a qualified index on the first business day of the calendar year in which a derivative is issued, whereas the 2013 proposed regulations generally required testing each time a foreigner acquired the derivative.17 The new regulations generally retain the definition of “qualified index.” However, the new reg-ulations remove the requirement in the 2013 proposed

diVideNd-equiVAleNt PAYmeNt WithholdiNG ruleS For equitY deriVAtiVeS

January–February 2016 19

regulations that any rebalancing of the index be based on objective rules, thereby permitting the S&P 500 Index and other major stock indices that rebalance based on subjective criteria to qualify as qualified indices.18 The new regulations also allow indices to qualify as qualified indices if they are referenced by futures or option contracts that trade on certain foreign exchanges or boards of trade if U.S. stock comprises less than 50 percent of their weighting.19 The 2013 proposed regulations required an index to be referenced by futures or options contracts that trade on a domestic securities exchange or board of trade.No withholding until payment or settlement. The new regulations do not require a short party to withhold on a foreign long party until a payment is made under the derivative or there is a final settlement of the derivative.20 This rule is less burdensome than the analogous rule in the 2013 proposed regulations, which would have required brokers to withhold and remit tax on dividend-equivalent payments during the term of the derivative, even if no payments were made. However, the new regulations (like the 2013 proposed regulations) require withholding on a final settlement (including a lapse of an option) even if the withholding agent is not required to make a payment to the foreign counterparty.21

No constant delta rule. The new regulations eliminate the rule under the 2013 proposed regulations under which a derivative that was expected to have a constant delta was treated as having a delta of 1.0 with respect to an adjusted number of shares. Thus, for example, dividend-equivalent payments on a swap that refer-ences 100 shares of IBM and has a constant delta of 0.50 generally will not be subject to withholding under the new regulations, whereas the 2013 proposed regulations would have treated this swap as referencing 50 shares of IBM and having a delta of 1.0.No withholding on qualified derivatives dealers. To reduce the potential for multiple withholdings on a single stream of dividends, the new regulations allow foreign securities dealers and foreign banks to avoid being subject to withholding on dividends and dividend-equivalent payments by agreeing to assume primary withholding and reporting responsibility when they pass those amounts through to customers.22

Delayed effective date. As mentioned above, under the new regulations, withholding is required on equity derivatives issued after 2016.23 The 2013 proposed regulations generally would have applied to all payments made on an equity derivative after 2015 regardless of when the derivative was entered into.

II. The History and Purpose of Code Sec. 871(m)

Payments of U.S.-source dividends to foreigners generally are subject to a 30-percent U.S. withholding tax.24 By con-trast, payments under most equity derivatives historically were not subject to withholding, even if they were contin-gent upon, or determined by reference to, a U.S.-source dividend.25 Thus, substitute dividend payments on equity swaps with respect to U.S. equity securities generally were not subject to withholding.

In the early 2000s, several banks entered into “yield-enhancement strategies” with foreign hedge funds that used derivatives to eliminate dividend withholding on U.S. equities. Under these strategies, a foreign hedge fund trans-ferred its U.S. stock to a bank shortly before the stock’s ex-dividend date, and then entered into an equity swap with the bank that referenced the stock, thereby preserving the fund’s economic position with respect to the stock. This permitted the fund to receive substitute dividend payments under the equity swap free of withholding and to reacquire the stock shortly after the dividend payment. A 2008 report by the Senate’s Permanent Subcommittee on Investigations detailing this transaction led to the enactment of Code Sec. 871(m).26

Under Code Sec. 871(m), any dividend-equivalent pay-ment to a foreigner under an equity swap is subject to a 30-percent U.S. withholding tax if:

the foreigner transferred the underlying stock to its counterparty in connection with the transaction (i.e., the underlying stock “crossed in”);the counterparty transferred the underlying stock to the foreigner at the termination of the transaction (i.e., the underlying stock “crossed out”);the underlying stock was not readily tradable on an established securities market; orthe underlying stock was posted as collateral to the foreigner in connection with the transaction.27

Thus, the statutory language of Code Sec. 871(m) imposes withholding on a limited group of equity swaps that, like the yield-enhancement strategies of the early 2000s, bear indicia of actual stock ownership by a foreigner through an agent.

Code Sec. 871(m) also gives the IRS authority to iden-tify other swaps that should be subject to withholding and imposes withholding tax on every equity swap beginning on March 18, 2012, except to the extent that regula-tions are issued that provide that the equity swap does not have the potential for tax avoidance.28 The IRS has repeatedly extended the March 18, 2012, deadline, and


the new regulations further extend the deadline to 2017, at which point the delta test and substantial equivalence test will replace the four statutory factors described above to determine whether a transaction has the potential for tax avoidance.29

Finally, Code Sec. 871(m) authorizes the IRS to impose withholding tax on “any other payment” that it determines is “substantially similar” to payments that are otherwise subject to withholding under Code Sec. 871(m).30 The new regulations use this authority to impose withholding tax on all U.S. equity derivatives, including debt instru-ments with embedded equity-linked components, and not just equity swaps. The new regulations retain a nominal distinction between “notional principal contracts” (i.e., swaps) and other “equity linked instruments,” but the rules apply equally to both classes of instruments. This memo-randum refers to both categories as equity derivatives.

In 2012, the IRS issued an initial set of proposed regula-tions under Code Sec. 871(m).31 In response to consider-able criticism from market participants, in 2013, the IRS withdrew those proposed regulations and issued the 2013 proposed regulations.32 The new regulations revise and finalize the 2013 proposed regulations and include rules relating to the substantial equivalence test and qualified derivatives dealers in temporary and proposed form.

III. The New Regulations

A. In GeneralUnder the new regulations, all equity derivatives are po-tentially subject to withholding under Code Sec. 871(m). To determine whether an equity derivative is subject to withholding under Code Sec. 871(m), the delta test (for simple contracts) or the substantial equivalence test (for complex contracts) is applied to the derivative at inception or upon a subsequent significant modification of the deriva-tive.33 If the derivative satisfies the relevant test, then any dividend-equivalent payments with respect to the derivative are subject to a 30-percent withholding tax (or less under a tax treaty) upon their payment or upon the termination of the derivative (including by offset or lapse). If the derivative does not satisfy the delta test or substantial equivalence test at issuance, then it is never subject to withholding (unless it is significantly modified and the significantly modified derivative is subject to Code Sec. 871(m)).34

B. The Delta Test for Simple Contracts

The delta test applies only to simple contracts.35 A deriva-tive is a simple contract if:

all amounts to be paid or received on maturity, at exercise, or on any other payment determination date with respect to the underlying equity security are calculated by reference to a single, fixed number of shares of the equity security;the number of shares of the underlying equity security can be determined when the contract is issued; andthe derivative has a single maturity or exercise date with respect to which all amounts (other than any upfront payment or any periodic payments) are re-quired to be calculated with respect to the underlying equity security.36

For this purpose, the number of shares of an underlying security generally is the number of shares of the underlying security stated in the contract. However, if the transaction modifies that number by a factor or fraction or otherwise alters the amount of any payment, the number is adjusted to take into account the factor, fraction or other modifica-tion.37 Thus, if the long party to a transaction receives or makes payments based on 200 percent of the appreciation of 100 shares of stock, the number of shares of the underly-ing security is 200 shares. A contract has a single exercise date even though it may be exercised by the holder at any time on or before the stated expiration of the contract.38 Thus, an American-style option is a simple contract, even though the option may be exercised by the holder at any time on or before the expiration of the option, so long as amounts due under the option are determined by reference to a single, fixed number of shares on the exercise date.

If a simple contract has a delta of 0.80 or more, it is subject to withholding under Code Sec. 871(m).39 Delta is the ratio of the change in the fair market value of a derivative to a small change in the fair market value of the number of shares of the equity security referenced by the derivative.40 The higher a derivative’s delta, the better its fair market value tracks the fair market value of the underlying, and the more economically equivalent it is to the underlying. A “delta one” derivative tracks the underlying on a dollar-for-dollar basis.

Under the new regulations, the delta of a derivative is tested only when the derivative is issued.41 Although this rule simplifies the 2013 proposed regulations (which, as mentioned above, tested a derivative’s delta on multiple occasions), it has the unfortunate consequence of caus-ing options and other derivatives that are listed on an exchange to be treated differently from their over-the-counter analogs. A listed option is treated as issued each time it is acquired from the exchange (and not when it is listed) and, because of the manner in which listed options are traded, a transfer of a listed option also may be treated as an issuance under the new regulations. Thus, the delta



of a listed option generally must be tested each time a foreigner acquires the option from the exchange, and may also have to be tested each time the option is subsequently transferred to a foreigner, whereas the delta of an over-the-counter option is tested only when the option is first sold. (If the over-the-counter option is subsequently significantly modified, it would be treated as reissued on the date of the modification, and the modified option therefore would be reevaluated on the date of the modification.)42 Similarly, if an issuer lists a class of equity-linked notes on an exchange, and investors purchase the notes from the exchange at dif-ferent times, then the notes will be treated as issued upon each acquisition (and not when the notes are listed).

The delta of an equity derivative that is embedded in a debt instrument or other derivative is determined without taking into account changes in the market value of the components of the debt instrument or other derivative that are not directly related to the equity element of the instrument (such as the debt component of a convertible debt instrument).43

The new regulations provide a rule of administrative convenience for derivatives with more than nine refer-ence stocks. If the short party holds an exchange-traded security (such as an exchange-traded fund) as a hedge, and the exchange-traded security references substantially all of the underlying securities, then, instead of calculat-ing a separate delta for each referent, the short party may calculate the derivative’s delta with respect to the hedge.44 Short parties to index-linked derivatives may find this rule helpful where the reference index is not a “qualified index” (as described below in Part III.H.1).

As mentioned above, the 2013 proposed regulations included a 0.70 delta threshold, and the new regulations increased this threshold to 0.80. We suspect that the IRS and the Treasury always expected the final regulations to use a 0.80 delta standard. Eighty percent is a common threshold for tax purposes45; 70 percent is not. Moreover, practitioners often use an 80-percent delta standard to determine whether a party to a derivative “constructively owns” a financial asset under Code Sec. 1260. It would have been odd to apply a lower standard under Code Sec. 871(m) than the standard used to test constructive ownership.46

C. The Substantial Equivalence Test for Complex Contracts

A derivative that references a U.S. equity security and does not qualify as a simple contract is referred to in the new regulations as a “complex” contract.47 For example, if a derivative provided a foreigner with 200 percent of a reference stock’s upside, subject to a cap, and 100

percent of the reference stock’s downside, then it would not qualify as a simple contract and would be treated as a complex contract because payments are not calculated by reference to a single, fixed number of shares of the underlying security.48

Similarly, “worst-of ” basket notes (whose return is calculated by reference to the worst-performing stock in a basket) and notes with “digital” returns (whose return does not fluctuate smoothly in correlation to the price of the reference stock) are treated as complex contracts.

As mentioned above, delta is the ratio of the change in the fair market value of a derivative to a small change in the fair market value of the number of shares of the equity security referenced by the derivative.49 Delta is more dif-ficult or impossible to determine for complex contracts that reference different shares or different numbers of the same shares depending on the performance of the underlying securities. Accordingly, the new regulations introduce the substantial equivalence test to determine which complex contracts are subject to withholding under Code Sec. 871(m).50

To apply the substantial equivalence test, the new regulations require that a “simple contract benchmark” be established. The simple contract benchmark is a simple contract that is closely comparable to the complex contract, has a delta of 0.80, references the applicable underlying security referenced by the complex contract and has the same maturity as the complex contract.51 The relationship between the simple contract benchmark and the shares underlying it is compared to the relationship between the complex contract and the shares that would be used to hedge it over the range of prices of the under-lying security represented by an increase in price by one standard deviation and a decrease in price by one standard deviation.52 If the proportionate difference between the change in value of the complex contract and the change in value of its hedge within the standard deviation range is equal to or less than the corresponding change for the simple contract benchmark and the shares underlying it, then the complex contract tracks its hedge more closely than the simple benchmark contract tracks its hedge (i.e., the shares underlying it). Since the simple benchmark contract has a delta of 0.80 and the complex contract has a greater correlation with its hedge, the complex contract is subject to withholding under Code Sec. 871(m).53

The substantial equivalence test was not part of the 2013 proposed regulations. As a result, the test appears in the form of temporary and new proposed regulations, and the IRS has requested comments on the test’s effective-ness, administrability and application to contracts with multiple referents.


If a complex contract references more than nine stocks and, to hedge the complex contract, the short party holds an exchange-traded security (such as an exchange-traded fund) that references substantially all of the underlying securities, then the short party may treat the exchange-traded security as the underlying stock for purposes of the substantial equivalence test.54

The new regulations do not describe how to test for sub-stantial equivalence if a complex contract references more than one but fewer than 10 stocks or references more than nine stocks but the short party does not hold an exchange-traded security as a hedge. Instead, the new regulations provide simply that taxpayers should apply “the principles of the substantial equivalence test” to complex contracts that are not explicitly addressed.55 Short parties to derivatives with multiple referents might develop different methods of applying the principles of the substantial equivalence test.

D. Dividend-Equivalent Payments

Once an equity derivative satisfies the delta test or the substantial equivalence test, “dividend-equivalent pay-ments” under the derivative are subject to withholding.

1. Definition of “Payment”A payment for these purposes includes any gross amount that references the payment of a dividend and that is used to compute any net amount transferred to or from the long party, even if the long party makes a net payment to the short party or no amount is paid because the net amount is zero.56 Thus, a short party that is not required to make net payments to the long party may still have withholding obligations that it would have to fund itself, unless it negotiates to receive indemnification payments from the long party.

One of the most controversial features of the new regula-tions is their retention of the rule from the 2013 proposed regulations that a payment includes not only an actual dividend payment but also an estimated dividend payment that is implicitly taken into account in computing one or more of the terms of the transaction, such as interest rate, notional amount or purchase price.57 Effectively, this means that all equity derivatives that satisfy the delta test or the substantial equivalence test and reference dividend paying U.S. stock will be subject to withholding, even if they do not provide for the payment of substitute divi-dend payments to the long party and the long party does not bear any economic risk with respect to the amount of future dividends.

For example, assume that a contract a delta of 0.90 provides a foreigner with IBM’s upside and downside,

but not its dividends. Under the new regulations, the foreigner will be subject to withholding on a “dividend-equivalent payment” based on the actual dividends paid by IBM (or based on estimated dividends, if the short party specifies a reasonable estimate at issuance), even though the foreigner is not entitled to any dividends. Effectively, the contract deems the foreigner to receive a substitute dividend payment (subject to gross basis withholding) and then pay the dividend back to its counterparty (without a deduction or other offset against the withholding). This is true even if no payment is required under the contract until termination and, at termination, the foreigner is not entitled to receive any amounts.

It is easy to understand why the IRS and the Treasury included this rule for short-term derivatives. A delta-one price-return-only derivative issued very shortly before the reference stock’s ex-dividend date provides the foreign long party with the economic equivalent of a dividend because the short party bears little dividend risk (the amount of the dividend has been declared and is unlikely to change).58 However, the rule potentially imposes withholding on amounts that a long party is not entitled to in the case of longer-term contracts and even short-term options that lapse and therefore could be subject to legal challenge.

It is hard to imagine that Congress intended the statu-tory language of Code Sec. 871(m) to introduce a tax on deemed payments. Code Sec. 871(m) imposes a tax on “payments” that are contingent upon, or determined by reference to, U.S.-source dividends.59 There is no sug-gestion in the statute, or in the corresponding legislative history, that Congress intended the word to include an “implicit dividend” that is not economically received by the long party. Imagine if the IRS and the Treasury wrote a regulation that deemed foreigners to receive dividends subject to withholding when no dividends were actually paid and the foreigners did not receive any economics represented by a dividend.60

Moreover, the new regulations’ broad definition of “payment” arguably violates the nondiscrimination pro-visions of many income tax treaties to which the United States is a party. These provisions generally prohibit the United States from imposing a more burdensome tax on residents of the other signatory state than it imposes on U.S. residents.61 The United States does not tax U.S. residents on implicit dividends with respect to price-return-only contracts.62

The new regulations contain a presumption that, in cer-tain cases, mitigates the harsh result of the implicit dividend rule. Under the new regulations, if the short party specifies a reasonable estimated dividend amount in the offering or transaction documents at issuance, and the long party is



not entitled to a “true up” or other upward adjustment for actual dividends, then the short party is treated as paying the estimated amounts.63 The new regulations specifically provide that, if the underlying security is not expected to pay a dividend, a reasonable estimate of the dividend amount may be zero.64 Thus, presumably, a delta-one price-return-only swap on Berkshire Hathaway (which histori-cally has not paid dividends) that provides for a dividend estimate of zero would not be subject to withholding, even if Berkshire Hathaway declares a dividend during the term of the swap, as long as the foreigner in fact does not receive any economics with respect to the dividend.

However, the dividend estimate will apply for determin-ing the amount of withholding even if the actual dividend payments turn out to be less than the estimated amount. Thus, if the parties to the derivative estimate the amount of the dividend for withholding tax purposes, the foreign long party may be deemed to receive a dividend in excess of any dividend actually paid on the underlying stock.65

Foreign long parties that enter into price-return-only derivatives should negotiate the amount of the reason-able estimated dividend amount to limit their potential withholding liabilities.

2. Amount of WithholdingFor simple contracts, the amount of withholding under Code Sec. 871(m) is 30 percent of the product of three items: (1) the per-share dividend amount, (2) the number of reference shares, and (3) the derivative’s delta.66

The per-share dividend amount. If the short party speci-fies a reasonable estimated dividend in the relevant offering document or operative documents and the long party is not entitled to a true up for actual divi-dends, then the amount of the per-share dividend is the lesser of the estimate and the actual dividend.67 If the derivative “trues up” or otherwise adjusts for the actual dividend, then the true-up payment (in addition to the estimated dividend) is added to the per-share dividend amount.68 In all other cases, the per-share dividend is the actual dividend.69

The number of reference shares. The number of reference shares is adjusted to take into account any “leverag-ing” provided by the derivative.70 For example, if a total return swap provides for 125 percent upside and downside with respect to 100 shares of stock, then the number of reference shares is 125.The derivative’s delta. A derivative’s delta is determined at initial issuance.71

For complex contracts, the amount of the withholding is 30 percent of the product of two items: (1) the per-share dividend amount (determined as described above), and

(2) the amount of underlying stock that would fully hedge the contract at initial issuance.72

E. Timing of Withholding

As mentioned above, because dividend-equivalent pay-ments include gross amounts that reference the payment of a U.S.-source dividend, and either may not be payable to the long party or may be offset or credited against amounts payable by the long party, the new regulations may impose withholding in excess of the amount due to the long party under the derivative.

To limit the situations in which a short party has to withhold but lacks funds from which to withhold, the new regulations provide that withholding is not required until the later of two events73:

A payment is made by either party, or the derivative is disposed of or terminates. A payment must actually be made to trigger withholding. An upfront or premium payment is not treated as a payment for this purpose.74 Similarly, a payment does not occur if each party is required to make an equal periodic payment so that no net payment is made. However, a disposition of a derivative, including by settlement, offset, termi-nation, expiration, lapse or maturity, is treated as a payment subject to withholding.75

Under a rule of administrative convenience, if a derivative references a basket of more than 25 U.S. equity securities, then the short party is permitted to treat all dividends on the securities as paid on the last day of the calendar quarter.76 For example, suppose that a delta-one total return swap on a basket of 25 U.S. stocks requires the foreign long party to make monthly LIBOR-based payments. Under this rule, the short party can withhold at the end of each cal-endar quarter instead of each month.77 Short parties to basket-linked derivatives may find this rule helpful where the reference basket is not a “qualified index” (as described below in Part III.H.1).The dividend equivalent amount is determined. The dividend equivalent amount generally is determined on the earlier of the dividend record date and the day immediately preceding the ex-dividend date.78

This rule still requires withholding agents to satisfy their withholding obligations from their own funds in a number of situations. For example, on the lapse of an option, a short party may be required to remit withholding to the IRS in excess of the premium it has received. Moreover, if a deriva-tive is sold or assigned, it is unclear whether withholding responsibility falls on the short party (who may not know of the transfer), the transferee (who may not have sufficient


information to determine the amount of withholding), or the long party’s broker (who appears to be the most ap-propriate withholding agent in this scenario, but who the new regulations do not clearly designate as the withholding agent in this scenario). In any case, the withholding agent may not have funds from which to withhold, unless it has negotiated to receive the funds from the long party.

Short parties have already required long parties to indem-nify them in many master trading agreements so that they can remit the proper amount of withholding to the IRS.79

F. Related Transactions

1. In GeneralIf a foreigner or a person related to the foreigner enters into or acquires two or more positions that would have been subject to withholding under Code Sec. 871(m) if they were a single derivative and are entered into “in con-nection with” each other (whether or not they are entered into simultaneously or with the same counterparty), then the positions are combined and are subject to tax under Code Sec. 871(m).80 For example, if a foreigner enters into an equity swap with a delta of less than 0.80 and, in con-nection with entering into the swap, enters into another derivative so that the combined delta of the two derivatives is 0.80 or more, the foreigner will be subject to withhold-ing under Code Sec. 871(m) on the two derivatives.

Once a transaction becomes subject to withholding under this rule, it remains subject to withholding, even if the foreigner terminates some of the related positions and continues to hold only positions with a combined delta of less than 0.80.81 By contrast, if a foreigner acquires a single derivative with a delta of 0.80 or more, and then significantly modifies the derivative so that the delta of the modified derivative is less than 0.80, then the modified derivative will not be subject to withholding.

2. “In Connection with”The regulations do not define the “in connection with” standard. However, the new regulations provide brokers that act as short parties with two helpful presumptions that apply for purposes of determining their withholding obligations. First, a short-party broker may presume that transactions are not entered into in connection with each other if the long party holds the transactions in separate accounts, so long as the broker does not have actual knowledge that the long party used the separate accounts to avoid Code Sec. 871(m) or that the transactions were entered into in connection with each other.82 Second, a short-party broker may presume that transactions entered into at least two business days apart are not entered into in

connection with each other, so long as the broker does not have actual knowledge that the transactions were entered into in connection with each other.83 Short parties that are brokers and enter into transactions that do not satisfy the conditions for these presumptions are required to exercise “reasonable diligence” to determine whether the transac-tions were entered into in connection with each other.84

These presumptions do not apply to the long party.85 Accordingly, if the presumptions apply, the long party may owe tax that is not withheld by the short party. However, the IRS will presume that a long party did not enter into two or more transactions in connection with each other if the long party properly reflected those transactions on separate trading books, or if the long party entered into the transactions at least two business days apart.86 The IRS may rebut either presumption with facts and circumstances showing that the transactions were entered into in connec-tion with each other and will presume that a long party did enter into the transactions in connection with each other if the transactions were entered into on the same trading book within one business day of each other.87 The IRS will treat all transactions as entered into at 4:00 p.m.88

G. Partnership-Linked Derivatives

The new regulations “look through” a partnership to eq-uity derivatives held by the partnership if the partnership is a “covered partnership.”89 A covered partnership is a partnership that is a securities dealer or securities trader, has significant investments in securities or directly or in-directly holds an interest in a lower-tier partnership that is a covered partnership.90 A partnership has significant investments in securities if:

at least 25 percent of the partnership’s assets consist of U.S. stock or U.S. equity derivatives; orthe partnership holds at least $25 million of U.S. stock and U.S. equity derivatives.91

For purposes of this test, the value of a partnership’s assets is tested on the last day of the tax year immediately preceding the issuance of the partnership-linked deriva-tive, unless either party actually knows that a subsequent transaction has caused the partnership to cross either of the thresholds.92 In addition, the value of a swap, futures contract, forward contract option or “similar” contract held by the partnership is deemed to be the contract’s notional amount.

The 2013 proposed regulations would have looked through all partnerships if U.S. stock and U.S. equity derivatives represented more than 10 percent of their value. However, we suspect that the relaxation of this rule will have limited use. Derivatives with deltas of greater than



0.80 with respect to nonpublicly traded partnership inter-ests raise ownership issues. Asset management companies that are publicly traded partnerships (such as AllianceBer-nstein Holding L.P., Kohlberg Kravis Roberts & Co. L.P., The Blackstone Group L.P. and Oaktree Capital Group, LLC) will be looked through because they hold interests in lower-tier partnerships (such as hedge funds or private equity funds) that are covered partnerships because they have significant investments in securities. Publicly traded natural energy partnerships may not be treated as covered partnerships, but likely also would not have been covered partnerships under the 2013 proposed regulations.

When the partnership look-through rule does apply, it will be very difficult for short parties to administer. A partnership discloses an investor’s allocable share of U.S.-source dividends on Schedule K-1. The partnership is not required to provide Schedule K-1 to investors until the due date for filing the partnership’s tax return, which may be later than the date that payments are required to be made on a derivative that references the partnership. Moreover, Schedule K-1 does not disclose the amount of dividend-equivalent payments that the partnership received under U.S. equity derivatives. Accordingly, short parties may avoid entering into derivatives that reference partnership interests, feel compelled to over-withhold on derivatives that reference partnerships or demand indemnification for any liability they incur for under-withholding.

H. Exceptions from Withholding

1. Qualified Indicesa. In General. The new regulations provide an exemp-tion from U.S. withholding tax under Code Sec. 871(m) for dividend-equivalent payments made with respect to a “qualified index.”93 In general, a qualified index is a pas-sive, diversified index of publicly traded securities that is widely used by market participants.94 The two types of qualifying indices are broad-based indices and non-U.S. indices, each as described below.

The new regulations determine whether an index is a qualified index as of the first business day of the calendar year in which the transaction is issued.95 Thus, if a deriva-tive with respect to an index is issued on June 30, the index is tested as of January 1, even if the index is no longer a qualified index on June 30. However, if a principal pur-pose of the transaction is to use this rule to avoid Code Sec. 871(m), the anti-abuse rule described in Part III.K. would disqualify the index.

b. Broad-Based Index. The first type of qualified index is an index that at the time the derivative is entered into or acquired by the foreigner96:

references at least 25 securities (whether or not the securities are U.S. stock);references only long positions, other than short posi-tions with respect to the entire index (such as caps or floors) and short positions that represent no more than five percent of the aggregate value of the index’s long positions;does not contain any one U.S. stock that represents more than 15 percent of its weighting, or any collec-tion of five or fewer U.S. stocks that together represent more than 40 percent of its weighting;is modified or rebalanced only according to publicly stated, predefined criteria (which may require inter-pretation by the sponsor);did not provide a dividend yield in the immediately preceding calendar year from U.S. stock that exceeded 150 percent of the annual dividend yield reported on the S&P 500 index for that year; andis referenced by futures or option contracts that trade on either (1) a national securities exchange that is reg-istered with the Securities and Exchange Commission or a domestic board of trade that is designated as a contract market by the Commodity Futures Trad-ing Commission (CFTC), or (2) a foreign exchange or board of trade that the IRS has determined is a “qualified board of trade” under Code Sec. 1256,97 or that has an effective “no action” letter from the CFTC permitting direct access from the United States, if U.S. stock comprises less than 50 percent of its weighting and it otherwise meets the definition of a qualified index.

This exemption clearly was intended to permit a for-eigner to hold a total return swap that references the S&P 500 index without being subject to withholding tax. However, some broad-based indices are referenced by exchange-traded funds, but not by exchange-traded futures or option contracts.98 These indices would not be qualified indices. It is unclear why the regulations exempt an index-linked derivative from withholding tax only if the index is referenced by exchange-traded futures or option contracts, and not if the index is referenced by exchange-traded funds.

c. Non-U.S. Index. An index also is a qualified index if U.S. stocks represent no more than 10 percent of its weighting.99

Many global indices are too heavily weighted in U.S. reference stocks to satisfy this test and therefore would have to satisfy the broad-based test to be qualified indices. However, many global indices will not satisfy the broad-based test. For example, the MSCI World Index is traded on Eurex Deutschland (which is a qualified board of trade),


but U.S. stock consistently represents more than 50 per-cent of its weighting.100 There is no clear policy rationale for excluding the MSCI World index from the definition of “qualified index.”

2. Due BillsA purchase of publicly traded stock typically is not entered into the company’s books for three business days. To ensure that the proper investors receive the company’s dividends, stock exchanges typically set a stock’s ex-dividend date (which is the date on and after which the stock no longer trades with its dividend) two business days before the record date (which is the date on which the company checks its books to see who is entitled to the dividend). This way, only investors that purchased stock before the ex-dividend date will receive a dividend because only those investors will have been entered into the company’s books by the record date.

However, because stock prices adjust on an ex-dividend date to account for the dividend, a large special dividend could cause the price of a stock to plummet before the special dividend is paid, which could inappropriately trigger margin calls. To avoid this, for special dividends of at least 25 percent of a company’s stock price, stock exchanges typically set the ex-dividend date after the re-cord date. Then, to ensure that the proper investors still receive the dividend, stock exchanges require stock that is purchased after the record date but before the ex-dividend date to trade with a “due bill” attached. The dividend first is paid to the shareholders of record and then, on the due bill settlement date (which typically occurs two days after the ex-dividend date), the amount of the dividend is withdrawn from their accounts and paid over to the due bill holders.

Even though due bill payments are economically identi-cal to dividend payments, the tax law does not treat them as dividends.101 From a pure policy perspective, it would seem appropriate to treat due bill payments as dividend-equivalent payments. However, the new regulations generally exempt due bill payments of the type described above from withholding, presumably out of concern that requiring withholding on due bills could adversely affect the orderly functioning of the markets.102

3. M&A TransactionsThe new regulations exempt dividend-equivalent pay-ments from withholding if they are made to one or more long parties that are obligated to acquire more than 50 percent of the value of the underlying corporation.103

This exception is far narrower than it should be. Suppose that a foreign acquirer agrees to purchase 20 percent of the

outstanding stock of a domestic target and that, pursuant to the plan of acquisition, the target agrees to pay a pre-closing dividend to its current shareholders and to reduce the purchase price by the amount of the dividend. Under the new regulations, the stock purchase agreement would be a delta-one derivative, and the foreign acquirer would be deemed to receive a substitute dividend payment with respect to which the seller would be obligated to with-hold. In the context of an acquisition, this is the wrong result. The transaction is better viewed as a purchase price adjustment than as a dividend-equivalent payment and does not give rise to any obvious tax avoidance concerns.104 To avoid this trap for the unwary, the target would have to pay the dividend to the seller before the stock purchase agreement is signed, or after the stock is sold. However, each of these potential solutions may present commercial issues and could be subject to the anti-abuse rule described in Part III.K.

4. Other ExceptionsThe new regulations contain the following additional exceptions from withholding:

Section 305 Dividends. Under Section 305 of the Code, a change to the conversion price or conver-sion ratio of a convertible debt instrument held by a foreigner may be treated as a dividend and subject to withholding. To avoid multiple withholdings on the same dividends, the new regulations reduce the withholding under Code Sec. 871(m) by any amount treated as a dividend under Code Sec. 305.105

Life Insurance and Annuities. Life insurance, endow-ment and annuity contracts may include payments that are determined by reference to U.S. dividends (e.g., with respect to variable life insurance). However, under current law, foreigners generally are subject to withholding on payments and withdrawals from a life insurance, endowment or annuity contract issued by a domestic insurance company. The IRS and the Treasury concluded that the taxation of these contracts issued by domestic insurance companies is adequately addressed under existing law and that there is no Code Sec. 871(m) withholding with respect to these contracts.106 The IRS and the Treasury continue to consider whether Code Sec. 871(m) should apply to foreign life insurance, endowment and annuity con-tracts. The new regulations provide that, until further guidance is issued, no withholding under Code Sec. 871(m) is imposed on these contracts issued by a foreign corporation that is predominately engaged in an insurance business and would be taxable as an in-surance company if it were a domestic corporation.107



Employee Compensation. The new regulations provide that equity-based compensation, such as restricted stock, is not subject to withholding under Code Sec. 871(m).108 The grant of equity-based compensation may be subject to withholding as wages. In addition, af-ter restricted stock vests, a foreign holder will be subject to withholding on actual dividends paid on the stock.

I. Reporting by Brokers and Dealers

If only one party to a derivative is a broker or dealer, then the broker or dealer is required to exercise reasonable diligence to determine whether payments under the derivative are subject to withholding under Code Sec. 871(m)109 and must provide the other parties (including any agents or intermediaries) with the timing and amount of any dividend-equivalent payments, the derivative’s delta, the amount of any tax withheld and any other information necessary to apply the new regulations within 10 business days after the parties request the information. In all other cases, the short party must determine and provide this information.110

Accordingly, under the new regulations, brokers, dealers and other short parties are required to determine and re-port whether a derivative is a simple contract or a complex contract, its delta or substantial equivalence, whether any reference index is a qualified index, the amount of any dividend-equivalent payment and the timing and amount of any withholding.

Many structured notes and other derivatives are held through a depository (such as the Depository Trust & Clearing Corporation or its affiliates), and customers purchase the derivatives through brokers that face the depository. The ultimate customers are the long parties for tax purposes, but the issuer will not know the identities of these customers. To comply with the new regulations, issuers likely will have to set up call centers or websites to notify the ultimate customers whether their derivatives are subject to withholding.

J. “Cascading” Withholding

The new regulations may result in multiple withholdings on the same stream of dividends. For example, if a for-eigner holds U.S. stock and enters into a short forward contract with respect to the stock with another foreigner, it generally will be subject to withholding on dividends paid on the stock and will have to withhold on dividend-equivalent payments under the forward contract. The withholding tax on the dividend-equivalent payments would, in effect, be a second withholding tax with respect to the dividends.

Certain foreign financial institutions and foreign clearing houses can receive U.S.-source dividends and dividend-equivalent payments without being subject to withholding tax if they certify to the withholding agent that they are receiving the payments as custodians (and not as beneficial owners) and have entered into a “qualified intermediary” agreement with the IRS under which they have agreed to assume primary withholding responsibil-ity with respect to the payments. However, dealers often cannot act as qualified intermediaries with respect to a dividend or dividend-equivalent payment because they receive the payment as beneficial owners (for example, as part of a dynamic hedge that offsets one or more transac-tions to which the dealer is a short party).

The new regulations mitigate cascading withholding by expanding the qualified intermediary regime to include “qualified derivatives dealers.”111 A qualified derivatives dealer is a qualified intermediary that is either:

a securities dealer that is regulated as a dealer in the jurisdiction in which it was organized or operates; ora bank that is regulated as a bank in the jurisdiction in which it was organized or operates (or a wholly owned affiliate of such a bank) that issues U.S. eq-uity derivatives to customers and receives dividends or dividend-equivalent payments on its hedges of these derivatives.112

Under the new regulations, a qualified derivatives dealer would not be subject to withholding on dividends or dividend-equivalent payments if it:

certifies that it is acting as a qualified derivatives dealer;agrees to assume primary withholding and reporting responsibilities with respect to the payments and to determine whether payments it makes are dividend-equivalent payments;agrees to remain liable for tax on any dividends and dividend equivalents it receives to the extent that it does not make offsetting payments as a short party to another transaction that references the same stock; andcomplies with certain compliance review procedures.113

The qualified derivatives dealer regime was not part of the 2013 proposed regulations on which the new regulations are based, so the IRS has introduced it in the form of temporary and new proposed regulations. The preamble to the new regulations provides that the IRS intends to revise its current form of qualified inter-mediary agreement before 2017 to reflect the qualified derivatives dealer regime. It is likely that virtually all foreign securities dealers, foreign banks and affiliates of foreign banks that issue U.S. equity derivatives would become qualified derivatives dealers in order to eliminate withholding on their hedges.


K. Anti-Abuse Rule

The new regulations contain an anti-abuse rule that per-mits the IRS to subject any transaction to withholding if the transaction was entered into with a principal purpose of avoiding the regulations.114 The anti-abuse rule grants extraordinarily broad discretion to the IRS. A purpose may be a principal purpose even though other purposes outweigh it. Thus, notwithstanding any contrary provi-sion in the new regulations, the IRS may adjust the delta of a transaction, change the number of reference shares, adjust an estimated dividend amount, change the maturity, adjust the timing of payments, treat a transaction that references a partnership interest as referencing the assets of the partnership, and combine, separate or disregard

transactions, or otherwise depart from the new regulations as necessary to determine whether the transaction includes a dividend-equivalent payment.

For example, assume that a U.S. broker and a foreigner enter into a “dividend-stripping” partnership that holds a static pool of publicly traded U.S. stocks and allocates all dividends to the U.S. broker and all capital gains and losses to the foreigner. The purpose of the partnership is to provide the foreigner with price–return-only exposure to the stocks. The partnership would not be subject to the partnership look-through rule. However, under the anti-abuse rule, the IRS could look through the partnership and impose withholding on the foreigner’s partnership interest as if the foreigner had entered into a price-return-only swap with respect to the partnership’s stocks.


EndnotEs* this article is reprinted from J. tax’n Financial

Products, Vol. 13, No.3, at 21 (2015).1 t.d. 9734, irB 2015-41, 500 (Sept. 17, 2015).

All references to section numbers are to the Code, or to treasury regulations promulgated thereunder.

2 reg. §1.871-15(e)(1).3 reg. §1.871-15(i)(2)(ii).4 reg. §1.871-15(r)(3). the new regulations

would have imposed withholding on equity derivatives issued in 2016 that are still out-standing in 2018 and on all equity derivatives issued after 2016. the irS and the treasury subsequently revised these effective dates. See 80 Fr 75946 (dec. 7, 2015).

5 reg. §§1.871-15(d)(2)(i), (e)(1).6 reg. §1.871-15(a)(14)(i).7 temporary reg. §1.871-15t(h).8 temporary reg. §1.871-15t(h)(1).9 reg. §1.871-15(g)(2) (delta); temporary reg.

§1.871-15t(h)(1) (substantial equivalence).10 reg. §1.871-15(i)(2)(ii).11 reg. §1.871-15(g)(2).12 reg. §1.871-15(n)(1).13 reg. §1.871-15(n)(3)(i).14 reg. §1.871-15(n)(3)(ii).15 reg. §1.871-15(n)(5)(ii).16 reg. §1.871-15(l)(2).17 reg. §1.871-15(l)(2).18 reg. §1.871-15(l)(3)(v).19 reg. §1.871-15(l)(3)(vii)(B).20 reg. §1.1441-2(e)(8).21 reg. §1.1441-2(e)(8)(ii)(C).22 temporary reg. §1.871-15t(q).23 reg. §1.871-15(r)(3).24 See Code Sec. 871(a). income tax treaties may

reduce the withholding rate. in addition, u.S.-source dividends are not subject to withholding if the dividends are effectively connected to the foreigner’s u.S. trade or business. in this case, the dividends are instead subject to u.S. federal net income tax. See Code Secs. 881(a) and 882.

25 See reg. §1.863-7(b)(1) (source of swap in-

come generally determined by reference to the residence of the recipient); reg. §1.1441- 4(a)(3)(1) (no withholding on swaps); reg. §1.1441-2(b)(2)(i) (gains from the sale of property, including option premium and gains from the settlement of a forward contract, are not “fixed or determinable annual or periodical income” subject to withholding).

26 See Staff, u.S. Senate Permanent Subcom-mittee on investigations, dividend tax Abuse: how offshore entities dodge taxes on u.S. Stock dividends (Sept. 11, 2008), available online at www.hsgac.senate.gov//imo/media/doc/091108DividendTaxAbuse.pdf?attempt=2.

27 Code Sec. 871(m)(3). in addition, under Code Sec. 871(m)(2)(A), any substitute dividend paid to a foreigner under a securities loan or sale-repurchase transaction is subject to with-holding.

28 Code Sec. 871(m)(3)(B).29 reg. §1.871-15(r).30 Code Sec. 871(m)(2)(C).31 77 Fr 3108 (Jan. 23, 2012). 32 78 Fr 73079 (dec. 5, 2013).33 reg. §1.871-15(a)(6) (definition of “issue”).

A significant modification of a derivative is treated as a retirement of the unmodified derivative and an issuance of a new derivative with the modified terms. there are no clear rules as to when a nondebt derivative is treated as significantly modified.

34 As described above, the modified derivative would be treated as a new derivative for federal income tax purposes.

35 reg. §1.871-15(d)(2)(i), (e)(1).36 reg. §1.871-15(a)(14)(i).37 reg. §1.871-15(j)(3).38 reg. §1.871-15(a)(14)(i).39 reg. §§1.871-15(d)(2)(i), (e)(1).40 reg. §1.871-15(g)(1).41 reg. §1.871-15(g)(2).42 reg. §1.871-15(a)(6) (definition of “issue”).43 reg. §1.871-15(g)(1).44 reg. §1.871-15(g)(3).

45 See, e.g., Code Sec. 368(c); Code Sec. 1504.46 See New York State Bar Association tax Sec-

tion, Report on Proposed Regulations under Section 871(m), at 25–26 (may 20, 2014), available online at www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2014/Tax_Section_Report_1306.html.

47 reg. §1.871-15(a)(14)(ii).48 As mentioned above in Part iii.B., the number

of reference shares is adjusted to account for leverage. So, although the contract notionally references a single share, because the contract pays 200 percent of appreciation and 100 percent of depreciation, it would be deemed to reference two shares for appreciation and only one share for depreciation.

49 reg. §1.871-15(g)(1).50 the substantial equivalence test is a version of

the “proportionality” test that the Securities industry and Financial markets Association (SiFmA) recommended in its report on the 2013 proposed regulations. See SiFmA, Sub-mission on Proposed Regulations under Section 871(m), at 11 (may 7, 2014), available online at www.sifma.org/comment-letters/2014/sifma-submits-comments-to-the-irs-and-treasury-on-proposed-regulations-implementing-section-871(m)-of-the-internal-revenue-code/.

51 temporary reg. §1.871-15t(h)(2).52 over a normal distribution, approximately

68.27 percent of all outcomes occur within the range represented by one standard deviation from the mean. See Wikipedia, Standard Deviation (last visited Sept. 29, 2015), available online at https://en.wikipedia.org/wiki/Standard_deviation#Rules_for_ normally_distributed_data.

53 temporary reg. §1.871-15t(h)(1).54 temporary reg. §1.871-15t(h)(6). Also, as is

the case with the delta test, the substantial equivalence of an equity derivative that is em-bedded in a debt instrument or other derivative is determined without taking into account any



IRS Plans to Issue Built-in Gain, Allocation Regulations for Transfers to Partnerships with Related Foreign Partners*

By David Forst

I n Notice 2015-54,1 Treasury and the IRS state that they intend to issue regulations under Code Secs. 721(c) and 482, which will apply to controlled transactions involving partnerships. These regulations are intended to prevent

what the IRS considers as inappropriate shifting of income from U.S. partners to related foreign partners.

The regulations under Code Sec. 721 would require a U.S. partner contributing built-in gain property to a partnership with a related foreign partner to take the gain into account either immediately or periodically. The regulations will do this by forcing a partner to elect the remedial allocation method under Code Sec. 704(c) with respect to the built-in gain property or otherwise forego the application of Code Sec. 721(a). The new rules apply to both tangible and intangible property with a built-in gain.

The regulations under Code Sec. 482 would apply the principles and methods of Reg. §1.482-7 (the cost-sharing regulations) to controlled transactions involv-ing partnerships.

Regulations Under Code Sec.721(c)— Gain Deferral Method

In the Notice, the IRS states that it has elected to exercise its regulatory authority granted in Code Sec.721(c) to override the application of Code Sec. 721(a) in certain cases where the transfer of property to a partnership (domestic or foreign) would result in built-in gain on the property being includible in the gross income of a foreign person. The Notice states that the IRS has elected not to act pursu-ant to Code Sec. 367(d)(3) because the transactions at issue are not limited to transfers of intangible property.

The Notice states that Treasury and the IRS intend to issue regulations provid-ing that Code Sec. 721(a) will not apply when a U.S. transferor contributes an

david Forst is an Attorney at Fenwick & West, llP in mountain View, California.


item of Code Sec. 721(c) property (or portion thereof ) to a Code Sec. 721(c) partnership, unless the gain deferral method is applied with respect to such property.

Code Sec. 721(a) provides that neither a partnership nor any of its partners recognize gain or loss in the case of property being contributed to the partnership in ex-change for an interest in the partnership. The portion of the Notice dealing with the gain deferral method does not apply to transactions to which Code Sec. 721(a) otherwise would not apply.

The Notice defines Code Sec. 721(c) property generally as any property with a built-in gain. Built-in gain is the excess Code Sec. 704(b) book value of the property over the contributing partner’s adjusted tax basis in the property at the time of the contribution (and does not include gain created when a partnership revalues partnership property). The Notice does not state how to determine the book value of an item of property, but presumably, a book value amount will be respected if it reflects amounts that would be reasonably agreed to by partners acting at arm’s length.

A “Section 721(c) Partnership” is generally a partnership (domestic or foreign) if a U.S. person contributes Code Sec. 721(c) property to the partnership, and after the con-tribution and any transactions related to the contribution, (i) a related foreign person is a direct or indirect partner in the partnership and (ii) the U.S. transferor and one or more related persons own more than 50 percent of the interests in partnership’s capital, profits, deductions or losses. Relatedness is defined by reference to Code Sec. 267(b) or 707(b)(1).

The gain deferral method contains five requirements as follows:

(1) The Section 721(c) Partnership adopts the remedial allocation method described in Reg. §1.704-3(d) for built-in gain with respect to all Code Sec. 721(c) property contributed to the partnership.

In most cases, this requirement will be the most signifi-cant of the five. It effectively requires the taxpayer to elect between including its built-in gain in respect of the Code Sec. 721(c) property immediately (if it does not choose the remedial method and also follow the other requirements below) or including the built-in gain in installments (by choosing the remedial method and following the other requirements below).

Reg. §1.704-3(d)(2) provides rules under the remedial allocation method for determining the amount of book items. It states that the portion of the partnership’s book basis in property equal to the adjusted tax basis in the property at the time of contribution is recovered in the same manner as the adjusted tax basis is recovered. The remainder of the partnership’s book basis in the property

is recovered using any recovery period and depreciation method available to the partnership for the applicable property.2 The Notice does not alter these rules.

(2) During any tax year in which there is remaining built-in gain with respect to an item of Code Sec. 721(c) property, the Code Sec. 721(c) partnership allocates all items of Code Sec. 704(b) income, gain, loss and deduction with respect to that Code Sec. 721(c) property in the same proportion (for example, if income with respect to an item of Code Sec. 721(c) property is allocated 60 percent to the U.S. transferor and 40 percent to a related foreign person in a tax year, then gain, deduction and loss with respect to that Code Sec. 721(c) property must also be allocated 60 percent to the U.S. transferor and 40 percent to the related foreign person). The Notice states that this rule is necessary to ensure that income is not inappropriately separated from related deductions.

(3) The reporting requirements set forth in Section 4.06 of the Notice are satisfied.

(4) The U.S. transferor recognizes built-in gain with respect to any item of Code Sec. 721(c) property upon an acceleration event. Section 4.05 of the Notice defines an acceleration event as any transaction that either would reduce the amount of remaining built-in gain that a U.S. transferor would recognize under the gain deferral method if the transaction had not occurred or could defer the recognition of the built-in gain.

An acceleration event can occur after the seven-year built-in gain recognition period set forth in Code Sec.704(c). See Example 4 in the Notice (Acceleration Event requiring built-in gain recognition occurs nine years after the initial contribution). Therefore, if a taxpayer wants Code Sec. 721(a) treatment to apply, it must not only apply the remedial allocation method, but it must also forego the seven-year window for gain recognition set forth in the statute in favor of an unlimited window.

(5) The gain deferral method is adopted for all Code Sec. 721(c) property subsequently contributed to the Code Sec. 721(c) partnership by the U.S. transferor and all other U.S. transferors that are related persons until the earlier of (1) the date that no built-in gain remains with respect to any Code Sec. 721(c) property to which the gain deferral method first applied or (2) the date that is 60 months after the date of the initial contribution of Code Sec. 721(c) property to which the gain deferral method first applied.

Regulations Under Code Sec. 482In the second part of the Notice, Treasury and the IRS state that they intend to issue regulations similar to the

reGulAtioNS For trANSFerS to PArtNerShiPS With relAted ForeiGN PArtNerS


January–February 2016 31© 2016 E. RAHIMI-LARIDJANI AND E. HAUSER

The New Global FATCA: An Overview of the OECD’s Common Reporting Standard in Relation to FATCA*

By Eschrat Rahimi-Laridjani and Erika Hauser

I n June 2014, the Organisation for Economic Co-operation and Develop-ment (OECD) adopted the “Standard for Automatic Exchange of Financial Account Information” or “Common Reporting Standard” (CRS), and

in September of that year, the standard was endorsed by the G20 Finance Ministers.1 The adoption of the CRS represented the culmination of years of discussions among the governments of highly industrialized nations about how to tackle the age-old problem of tax evasion in an ever more globalized world and marked the beginning of a multi-year process that is intended to lead to a truly global regime of exchanging information on financial accounts. As part of these efforts, the OECD published the CRS Implementation Handbook in August 2015.2

Taxpayers have sought to evade taxation in their residence jurisdictions since time immemorial. But over the last few decades, opportunities to shift financial assets offshore and hide them in jurisdictions with high levels of bank secrecy increased greatly as barriers to movement of capital fell all over the world and financial markets and services became increasingly global. Jurisdictions started to fight back in the early years of the new millennium, notably with the adoption of the EU Savings Directive, aimed at increasing information reporting regarding interest income on savings across the European Union.3 As the decade progressed, the Great Recession brought with it increased needs for new sources of revenue. At the same time, a steady flow of revelations about wealthy individuals hiding vast sums of money in places like Switzerland and Liechtenstein angered compliant taxpayers and politicians the world over.4

It was this atmosphere that resulted in the enactment by the U.S. Congress of the provisions commonly known as the “Foreign Account Tax Compliance Act” (FATCA) in 2010.5 The passage of FATCA, with its bold extraterritorial reach and avowed goal of forcing financial institutions all over the world to do the IRS’s bidding in ferreting out U.S. persons that were hiding assets offshore, initially met with much consternation. However, as the implemen-tation of FATCA began to progress and included negotiations between the

EscHrat raHiMi-laridJani is a Spe-cial Counsel at milbank, tweed, hadley & mcCloy llP.

Erika HausEr is an Associate at mil-bank, tweed, hadley & mcCloy llP.


AN oVerVieW oF the oeCd’S CommoN rePortiNG StANdArd

U.S. Treasury and governments around the world, the tax administrations of many countries that were bat-tling the same problem as the United States began to appreciate the possibilities of a FATCA-like regime. On February 7, 2012, France, Germany, Italy, Spain and the U.K. issued a joint statement in support of FATCA where they pledged to enter into intergovernmental agreements with the United States in order to “inten-sify their co-operation in combatting international tax evasion.”6 Ultimately, these global tax transparency discussions led to the adoption of the CRS, which explicitly seeks to build on the foundation of FATCA and its intergovernmental agreements in order to build a global system for the gathering and exchange of fi-nancial account information.

The remainder of this column will provide more detailed background to the CRS and then focus on the key dif-ferences between this new reporting regime and FATCA.

Adoption of the CRSThe OECD has 34 member countries worldwide. In April 2013, shortly after early stages of FATCA were being rolled out, certain European members of the OECD announced that they would implement an auto-matic exchange of financial account information among themselves, in addition to the automatic exchanges under FATCA intergovernmental agreements.7 OECD govern-ments were very focused on the fact that the globalization of investment management had resulted in increasing numbers of taxpayers hiding assets outside their country of residence and that this undisclosed wealth represented a major, as yet untapped, source of taxable income for governments.8 In considering this problem, the OECD concluded that “countries have a shared interest in main-taining the integrity of their tax systems,” and published A Step Change in Tax Transparency, which set out concrete steps to implement the automatic exchange of information on a global scale.9 By September 2013, G20 Leaders agreed to introduce a standard for automatic information exchange by the next year. Since then, 96 jurisdictions have committed to incorporating the CRS into domestic law and undertaking the first exchange by 2017 or 2018, with 78 having signed multilateral agreements.10 Interestingly (though probably not sur-prisingly), the United States is not among them.11 The ultimate goal of these participants is a global regime for the automatic exchange of information regarding finan-cial accounts owned by persons resident in participating jurisdictions that are maintained at financial institutions operating in other participating jurisdictions, essentially

FATCA stripped of its U.S.-centric focus and applied on a global scale.

The OECD views three factors as critical to successfully implementing the proposed system of information ex-change: (i) a common standard on information reporting, due diligence and exchange of information; (ii) a clear legal and operational basis for the exchange of information; and (iii) common or compatible technical solutions.12 Based on these factors and a desire “to maximiz[e] efficiency and reduc[e] costs for financial institutions,” the OECD adopted a set of principles and recommendations for implementation that dovetail FATCA to a very significant extent.13 In particular, the CRS and its model agreement, to be entered into between the competent authorities of participating jurisdictions (the “Model Agreement on the Automatic Exchange of Financial Account Informa-tion to Improve International Tax Compliance”), draw extensively on the reciprocal Model 1 intergovernmental agreement (“Model 1 IGA”) for the implementation of FATCA. The CRS also seeks to build upon the IT sys-tems used to implement existing information exchanges between countries and, in particular, under FATCA. This is welcome news for financial institutions that have already invested significant funds and efforts to comply with the FATCA regime.14 However, given the multilateral nature of the CRS, shifting from FATCA compliance to global CRS compliance will bring new and difficult challenges.

Overview of the CRS Due Diligence and Reporting Requirements15

Before discussing the scope of the new reporting regime created by the CRS, it is useful to understand the four core requirements identified by the OECD for implementing the CRS. First, each participating jurisdiction must adopt the reporting and due diligence rules set out in the CRS under its domestic law and must put in place measures (e.g., penalties) to ensure their effective implementation. Second, each participating jurisdiction must select a legal basis for the automatic exchange of information, which could be an existing bilateral double-tax treaty, the Mul-tilateral Convention on Mutual Administrative Assistance in Tax Matters16 or bilateral Tax Information Exchange Agreements. Third, each jurisdiction must set up appropri-ate IT and administrative systems and dedicate adequate resources. And finally, each participating jurisdiction must put in place appropriate privacy protections and safeguards to prevent the misuse of confidential taxpayer data.17

The CRS is intended to collect and report information on Reportable Accounts held at Reporting Financial


Institutions in participating jurisdictions. Once an account is identified as reportable, a Reporting Financial Institu-tion resident or operating in a participating jurisdiction must report the following information to its jurisdiction of residence or operation for exchange with the jurisdiction of each account holder (or Controlling Person of a Passive Nonfinancial Entity (“Passive NFE”)) resident in another participating jurisdiction: (1) name, address, taxpayer identification number (TIN) and date and place of birth of an individual account holder or Controlling Person of a Passive NFE,18 (2) account number or its functional equivalent, (3) name and identifying number (if any) of the Reporting Financial Institution, (4) account balance or value as of the end of the relevant reporting period (or at account closure), and (5) information regarding income and/or gross proceeds on assets in or otherwise derived from the account.

The first step in applying the CRS is to identify whether an entity is a Reporting Financial Institution. For these purposes, Financial Institutions include Custodial or Depository Institutions, Investment Entities or Specified Insurance Companies.19 With the exception of Investment Entities, the relevant definitions are almost identical to the definitions in the Model 1 IGA.20 Reporting Financial Institutions exclude Financial Institutions that are Non-reporting Financial Institutions. The CRS provides that Nonreporting Financial Institutions include certain gov-ernmental entities, international organizations and central banks, certain types of retirement funds and credit card issuers, certain regulated collective investment vehicles, trusts whose trustees are Reporting Financial Institu-tions and other institutions that are specified under the applicable domestic law of a participating jurisdiction as presenting a low risk of being used to evade tax. Reporting Financial Institutions resident in a participating jurisdic-tion, their branches in that jurisdiction and branches of foreign entities operating in that jurisdiction must collect and report the financial account information described above to the tax authorities of that jurisdiction pursuant to that jurisdiction’s laws implementing the CRS.

Before looking at what makes an account “reportable” under the CRS, it is important to understand the scope of Financial Accounts. Financial Accounts for this purpose include Depositary Accounts, Custodial Accounts, Annu-ity Contracts, Cash Value Insurance Contracts and debt and equity interests in certain Investment Entities. As with Financial Institutions, the applicable definitions are gener-ally almost identical to those applicable under FATCA and the Model 1 IGA. However, the CRS does not provide an exception for publicly traded debt or equity and does not provide an exclusion for insurance contracts with a cash

value of less than $50,000. The CRS treats certain retire-ment and pension accounts, tax-favored savings accounts, term life insurance contracts, estate accounts, escrow ac-counts and certain Depositary Accounts linked to credit card overpayments as Excluded Accounts. In addition, the CRS permits each jurisdiction to designate as Excluded Accounts under domestic law other types of accounts that present a low risk of being used to evade taxes.

A Reportable Account is an account (other than an Excluded Account) held by one or more Reportable Persons or by a Passive NFE21 with one or more Control-ling Persons that are Reportable Persons. A Reportable Person is an individual or entity resident in (or effectively managed from) a participating jurisdiction other than a publicly traded company or an affiliate of such a company, a governmental entity, an international organization, a central bank or a Financial Institution. The OECD will publish lists of participating jurisdictions for purposes of this determination. A Controlling Person is a natural person exercising control over an entity.

The determination of whether an account is a Reportable Account is made in two steps, namely checking whether any account holder is (i) a Reportable Person, and/or (ii) a Passive NFE with one or more Controlling Persons that is a Reportable Person. This test gives jurisdictions two bites at the same apple; an account that is considered nonreport-able under the first test (e.g., because the account holder is a Passive NFE resident in a nonparticipating jurisdiction) may be reportable because it has a Controlling Person resident in a participating jurisdiction under the NFE look-through test. Moreover, the same account may be reportable to multiple jurisdictions. Once an account is deemed a Reportable Account, the Financial Institution must report annually the information described above with respect to that account.

In order to ensure a consistent approach to determin-ing whether an account is held by a Reportable Person, the CRS prescribes detailed due diligence principles for identifying the accounts of Reportable Persons or Passive NFEs with Controlling Persons that are “reportable.” The level of diligence required will vary depending on whether an account is an individual or an entity account and whether or not it is “pre-existing.” Diligence for pre-existing individual accounts valued at less than one million can be satisfied by using either the “Residence Address Test,” if a jurisdiction chooses to apply it,22 or an electronic search for specified indicia. Under the Residence Address Test, the financial institution can rely on documentary evidence (generally government-issued documents) establishing the account holder’s address in order to determine the reporting jurisdiction of such


account holder as long as the address is current and not a “hold mail” or “in care of ” address. If this test is inapplicable, an electronic search must be performed. The relevant indicia are (1) identification of the account holder as resident in a participating jurisdiction, (2) a current mailing or residence address in a participating jurisdiction, (3) a telephone number in a participating jurisdiction or no telephone number in the jurisdiction of the Reporting Financial Institution, (4) standing instruc-tions (other than for Depository Accounts) to transfer funds to an account in a participating jurisdiction, (5) a currently effective power of attorney or signatory author-ity granted to a person with an address in a participating jurisdiction, or (6) a “hold mail” or “in care of ” address in a participating jurisdiction if that is the only address on file.23 If the electronic search results in only finding a “hold mail” or “in care of ” address, the reporting in-stitution must complete a paper records search and/or obtain a self-certification from the account holder.24 For pre-existing accounts with a value in excess of one mil-lion, the requirements are more stringent. The Reporting Financial Institution must conduct an electronic search for indicia and, unless all relevant indicia are electronically searchable, must also conduct a paper records search and check whether the relationship manager assigned to the account has actual knowledge that it is held by a Report-able Person. If the searches result in only finding a “hold mail” or “in care of ” address, the Financial Institution must seek to obtain a self-certification. If unable to ob-tain the self-certification, the Financial Institution must report the account as an undocumented account. These procedures must be duplicated for the Controlling Person if any account holder is a Passive NFE.

With respect to pre-existing entity accounts, a jurisdic-tion can choose not to require due diligence review of accounts with a balance or value that does not exceed $250,000. For each account that must be diligized, the Reporting Financial Institution must review the infor-mation with respect to the account that it is required to maintain for regulatory or customer relationship purposes (including KYC/AML information). If this information indicates that an account holder is resident in a partici-pating jurisdiction, the account is reportable unless the Financial Institution obtains a self-certification from the account holder, or reasonably determines based on infor-mation in its possession or publicly available information that the account holder is not a Reportable Person. In ad-dition, a Reporting Financial Institution must apply the same procedures to determine whether a Passive NFE that is an account holder has one or more Controlling Persons that are themselves Reportable Persons.

For new individual accounts, a Reporting Financial Institution must obtain a self-certification from the ac-count holder and confirm the reasonableness of that self-certification based on other information in its posses-sion, including information obtained as part of its KYC/AML procedures. Each self-certification must establish the account holder’s name, residency for tax purposes, address, TIN, date of birth and be signed or affirmed and dated.25 If the self-certification indicates that the account holder is resident in a participating jurisdiction, the ac-count is treated as reportable. For new entity accounts, a Reporting Financial Institution similarly must obtain a self-certification (including to determine whether the account holder is a Passive NFE) and confirm its reason-ableness.26 The institution also must determine the status of Controlling Persons of a Passive NFE and may rely on self-certifications from the account holder or its Control-ling Persons. In general, it appears advisable for Reporting Financial Institutions to obtain self-certifications from each account holder (including any Controlling Persons if an account holder is a Passive NFE) whenever possible because such self-certifications can be used to satisfy the diligence requirements for both pre-existing and new entity accounts and can “cure” problematic indicia that are found in the searches.27

As noted above, CRS implementation requires each par-ticipating jurisdiction to incorporate these due diligence procedures into its domestic law. Therefore, even though the CRS establishes the basic framework for due diligence and reporting as described above, the details of the regime will likely vary from one jurisdiction to the next.28 These differences will be due in part to a number of optional provisions that were included to reduce costs and increase efficiency by providing jurisdictions the ability to further coordinate the CRS reporting regime with FATCA and other existing information exchange procedures.29 Though well intentioned, some of these provisions may cause head-aches to financial institutions. For example, jurisdictions may elect to use different methods for calculating account balances or alternative reporting periods that could result in a multiplicity of reporting deadlines and calculation methods for different branches of a single entity. As noted above, another optional provision permits the exclusion of pre-existing entity accounts with a value of less than $250,000 from due diligence procedures, thus eliminating the need for Financial Institutions to collect and store large volumes of data on accounts that are unlikely to have a significant relationship to tax evasion. It is worth noting, however, that different branches of the same institution may or may not benefit from this exclusion depend-ing upon where they are located. Many of the optional



provisions are also available in the context of FATCA implementation and it is expected that jurisdictions that have already entered into intergovernmental agreements with respect to FATCA will adopt the optional provisions that are consistent with FATCA. As in the case of FATCA, jurisdictions may permit Reporting Financial Institutions to seek the assistance of third-party service providers to assist with due diligence and reporting. This will help financial institution leverage the expertise of specialists in the field and will be welcome business to service providers operating in this space.

As a final step to implementation, each jurisdiction must become a party to an appropriate bilateral or multilateral agreement permitting automatic exchange and governing its confidentiality restrictions. As noted above, the OECD provides a few alternative bases, but recommends that jurisdictions sign the Multilateral Convention on Mutual Administrative Assistance in Tax Matters. With the proper legal authorization in place, jurisdictions must then focus on establishing compatible technical solutions to collect-ing, storing, encrypting and exchanging the relevant data.

Differences Between FATCA and the CRS

As the foregoing summary demonstrates, the CRS substan-tially overlaps with the reporting regime imposed under FATCA. There are, however, significant differences. The most notable differences are the lack of a penalty built into the CRS and the vastly greater scope of the CRS.

Under FATCA, noncompliant financial institutions will suffer a 30-percent withholding tax on U.S.-source income items and eventually gross proceeds from assets producing U.S.-source interest and dividends. Compliance with the information gathering and reporting regime is the price financial institutions have to pay in order to escape this penalty. In fact, the entire architecture of FATCA is based on the threat of withholding tax imposed by a nation that continues to play an indispensable role in international financial markets and thus has the ability to penalize noncompliance on a global scale. The CRS, on the other hand, is part of a multilateral effort that by its very nature cannot impose a similar threat. In the context of the CRS, penalties for noncompliance will have to be implemented under domestic law on a jurisdiction-by-jurisdiction basis. How stringent these penalties will be and how effectively they will be enforced will ultimately depend on each jurisdiction’s enthusiasm for penalizing its own financial institutions in order to advance—in the first instance—the tax collection efforts of other countries. This is an area in

which significant divergences in approach could evolve and where the lack of zeal of some participating jurisdic-tions might undermine the efficacy of the entire regime.

In this context, the lack of a global registration process or use of a concept similar to FATCA’s “Global Intermediary Identification Number” (GIIN) under the CRS will in-crease the burden associated with determining whether an institution is compliant. The lack of a withholding penalty under the CRS may make this difference less meaningful, but depending on the penalties to be imposed by partici-pating jurisdictions, the lack of central registration may complicate enforcement. It may also make it harder for tax administrations to process the vast amounts of data that will be generated under the new regime.

The other major difference relates to the relative scope of the two regimes. FATCA is narrowly focused on accounts of certain U.S. persons. The CRS, on the other hand, has a much broader scope and seeks to collect information on accounts of persons resident30 in all participating jurisdic-tions, which ultimately is intended to encompass most of the world. Thus, the volume of data that a financial institution needs to collect, categorize and provide to its home government will be vastly greater under the CRS. In addition, the scope of financial accounts and institu-tions that fall under the CRS greatly exceeds those subject to the FATCA regime. Unlike under FATCA, there is neither a $50,000 de minimis threshold for individual accounts subject to due diligence and reporting nor a blanket exclusion of local financial institutions. Moreover, once a pre-existing entity account exceeds a balance or value of $250,000, it becomes reportable under the CRS, while FATCA reporting does not apply until the account reaches a balance or value of $1 million. Thus, the CRS will impose obligations on financial entities that have not had to face the implementation of FATCA and for whom the development of adequate compliance systems may represent a serious burden. Given the vast number of individual accounts worldwide that are likely to fall below the $50,000 threshold (especially outside highly industrial-ized nations) and entity accounts between $250,000 and $1 million, the CRS may result in a tsunami of data that financial institutions and tax administrations will have to process—and that ultimately may not yield much useful information about tax evaders. While each participating jurisdiction is expected to create a single list of additional low-risk financial accounts and financial institutions that can be excluded from the reporting regime, which may mitigate some of these concerns, these lists will have to be vetted by the OECD and it may not be possible to introduce de minimis thresholds under those lists that were not adopted as part of the CRS.


A related challenge is that jurisdictions will join the CRS over time. Theoretically, each time a new jurisdic-tion joins the regime, a financial institution will have to diligize its accounts with a focus on the new adherent’s residents. Each due diligence exercise is expensive and time consuming for a financial institution. The CRS Handbook therefore contemplates that jurisdictions could permit their financial institutions to collect data on the tax residence of all accounts as part of the initial implementation and then store the data for residents of nonparticipating jurisdictions until those jurisdictions implement the CRS.31 Such preemptive data collection and storage, while undoubtedly to be welcomed from the perspective of financial institutions, may conflict with data protection laws in many jurisdictions and complicate the domestic law implementation of the CRS. Moreover, it is quite likely that jurisdictions will address this issue differently. As a result, different branches of the same financial institution may have to perform due diligence on their accounts at different times, limiting institutional “one-size-fits-all” approaches to CRS due diligence. As noted above, optional provisions also permit jurisdictions to use alternative approaches to calculat-ing account balances, alternative reporting periods and different phase-in times for adherence to the CRS and reporting of gross proceeds, resulting in yet more areas in which different parts of the same global financial institution may have to report different information on different accounts at different times, all complicating efforts to establish consistent systems and procedures across a global financial institution.

ConclusionThe adoption of the CRS and the commencement of its implementation moves the world closer to a global

exchange of information on financial accounts. The new regime will rest on the foundation of FATCA but will go well beyond FATCA with respect to the financial institutions required to report, the scope of persons whose accounts are reportable and the volume of ac-counts that are reportable. Overall, this is bad news for individuals seeking to hide funds outside their residence jurisdictions, though it remains to be seen how effective a system that depends upon local law implementation and enforcement ultimately will be. While the CRS should be good news for tax authorities, implementation of the CRS will present tax administrations with many logisti-cal challenges in receiving, processing and exchanging vast amounts of data as well as in mining mountains of data for information that will lead to the identification of untaxed assets. The resulting regime will also bring with it very significant additional compliance burdens for financial institutions that are already under pressure to comply with an ever-growing maze of regulation. In this regard, the OECD’s efforts to construct a due diligence and reporting regime on the basis of existing FATCA infrastructure are highly commendable, but the greater scope of reporting obligations and the staggered addition of participating jurisdiction will complicate implementation and reporting by financial institutions. In any event, the adoption of the CRS demonstrates that the brave new world inaugurated by FATCA continues to expand, introducing levels of automatic exchanges of tax-related information that would have been incon-ceivable only 10 years ago. Given how the CRS seeks to implement a FATCA-like system on a global scale, the ultimate irony may be that the U.S. Treasury has already announced that the United States “is just not in a position to commit” to the CRS in 2017 or 2018 when early-adopting countries will begin collecting and exchanging account information.32

EndnotEs


* this article is reprinted from J.tax’n Financial Products, No.3, at 13 (2015).

1 oeCd, Automatic exchange of Financial Ac-count information: Background information Brief, at 2 (2015), available online at www.oecd.org/ctp/exchange-of-tax-information/automatic-Exchange-Financial-Account-Infor-mation.pdf [hereinafter “Background Brief”].

2 oeCd, Standard for Automatic exchange of Financial information in tax matters implementation handbook, available online at www.oecd.org/ctp/exchange-of-tax-information/implementation-handbook-stan-dard-for-automatic-exchange-of-financial-information-in-tax-matters.pdf [hereinafter “CrS handbook”].

3 Council directive 2003/48/eC (2003), available online at http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=uriserv:l31050. this directive has since been repealed. See Repeal of the Savings Directive and the New EU-Switzerland Agreement, european Commission taxation and Customs union, available online at http://ec.europa.eu/taxation_customs/taxation/personal_tax/savings_tax/revised_directive/index_en.htm (discussing replacement of the Savings direc-tive with Council directive 2014/107/eu and its automatic exchange of financial account information between member States, includ-ing the carryover of certain income categories contained in the Savings directive).

4 See, e.g., Guy dinmore, Italians Gripped by Leaks Naming Liechtenstein Account Holders, Finan-cial times, mar. 20, 2008; lynnley Browning, Ex-UBS Banker Pleads Guilty to Tax Evasion, N.Y. times, June 20, 2008; hugh Carnegy & James Shotter, UBS Under Investigation over French Tax Evasion, Financial times, June 1, 2013; HSBC Bank Helped Client Dodge Millions in Tax, BBC News, Feb. 10, 2015.

5 hiring incentives to restore employment Act of 2010 (the “hire” Act) (P.l. No. 111-147), 111th Cong., 124 Stat. 71-118 (2010).

6 Joint Statement from the united States, France, Germany, italy, Spain and the united Kingdom regarding an intergovernmental Approach to improving international tax


Compliance and implementing FAtCA, u.S. treasury dep’t, available online at www.treasury.gov/press-center/press-releases/Documents/020712%20Treasury%20IRS%20FATCA%20Joint%20Statement.pdf.

7 oeCd, Common reporting Standard, at 5, 12, available online at www.oecd.org/ctp/exchange-of-tax-information/automatic-exchange-financial-account-information-common-reporting-standard.pdf [hereinafter “CrS”]. Any countries signing either a CrS implementing agreement or the model 1 iGA affirm their “desire to conclude an agreement to improve international tax compliance … based on [] reciprocal automatic exchange.” Id.; model 1 iGA, available online at www.treasury.gov/press-center/press-releases/Documents/reciprocal.pdf.

8 For example, in the united States, the Joint Committee taxation estimated FAtCA would raise approximately $800 million a year in revenue. JCT Estimates Budget Effect of HIRE Act, Joint Comm. tax’n, JCX-5-10 (2010).

9 CrS handbook, supra note 2, at 9; A Step Change in tax transparency: oeCd report for the G8 Summit (2013), available online at www.nytimes.com/2008/06/20/business/20tax.html?_r=0.

10 Background Brief, supra note 1, at 3 (list updated as of dec. 21, 2015).

11 Alison Bennett, Official: U.S. Won’t Meet Com-mon Standard for Tax by 2018, 199 daily tax rep. G-6, oct. 14, 2015.

12 CrS, supra note 7, at 7.13 Id., at 6.14 more than 80 countries have signed intergov-

ernmental agreements with the united States. See u.S. dep’t of the treasury, available online at www.treasury.gov/resource-center/tax-policy/treaties/Pages/FATCA-Archive.aspx.

15 For purposes of this discussion, all capitalized terms have the meaning prescribed in the CrS.

16 oeCd, the multilateral Convention on mutual Administrative Assistance in tax matters, available online at www.oecd-ilibrary.

org/taxation/the-multilateral-convention-on-mutual-administrative-assistance-in-tax-matters_9789264115606-en.

17 See CrS handbook, supra note 2.18 tiN and birth date are not required to be

reported for pre-existing accounts and place of birth is not required to be reported for pre-existing and new accounts if it is not required to be obtained under domestic law.

19 CrS, supra note 7, at Section Viii (defined terms).

20 Compare model 1 iGA with CrS (noting that the definition of investment entity under the CrS standard is more inclusive because it lacks the requirement that the entity “primarily” conducts the prescribed list of activities as a business and generally follows more closely the definition of “investment entity” in reg. §1.471-5(e)(4)).

21 A nonfinancial entity (NFe) can be either an active NFe or Passive NFe. Active NFe is defined consistently with the model 1 iGA. Passive NFes include nonfinancial entities that are not active NFes and certain investment entities that are not based in a participating jurisdiction.

22 this residence test was originally applied under the eu Savings directive. Council directive 2003/48/eC, supra note 2, at Section iii (due diligence for Pre-existing individual Accounts). Jurisdictions can, using the optional provisions, decide whether to apply this test to pre-existing and lower value accounts. See infra note 25 and accompanying text.

23 CrS, supra note 7, at 20. these indicia largely match the indicia under the model 1 iGA. Given that unlike FAtCA the CrS focuses on a residence-based approach to taxation, the indicia do not include citizenship and place of birth.

24 this rule is more stringent that under the model 1 iGA, which generally does not apply the “hold mail” rule to lower value, pre-existing accounts.

25 CrS handbook, supra note 2, at 57–58.26 Id., at 67.

27 in certain circumstances, publicly available information may be used to satisfy diligence requirements for a new account instead of obtaining a self-certification. Such informa-tion includes information published by an authorized government body or standardized industry coding systems. CrS handbook, supra note 2, at 60.

28 the oeCd hopes that consistency will be “significantly assisted through consultations across governments (such as legal drafters and advisers—including data protection ex-perts—and possibly with financial regulators) as well as with the business impacted and their representative bodies.” CrS handbook, supra note 2, at 10.

29 optional provisions include (1) alternative approaches to calculating account values; (2) use of other reporting periods; (3) phase-in for gross proceeds reporting; (4) filing of nil returns; (5) permitting third party service providers to fulfill obligations on behalf of financial institutions; (6) allowing due diligence procedures for new accounts to be used for pre-existing accounts; (7) allowing due diligence procedures for high value ac-counts to be used for lower-value accounts; (8) applying “residence address test” for lower-value accounts; (9) optional exclusion from due diligence for pre-existing of less than $250,000; (10) alternative documentation for certain employer sponsored group insur-ance or annuity contracts; (11) permitting use of existing standardized industry coding for due diligence; (12) currency translation; (13) expanded definition of pre-existing account; (14) expanded definition of related entity.

30 Consistent with the practice of most jurisdic-tions other than the united States, the CrS eliminates the concept of reporting on the basis of citizenship, opting instead for a regime based on whether the account holder is resident for tax purposes in the jurisdiction.

31 See CrS handbook, supra note 2.32 Bennett, supra note 11.

New Code Sec. 956Continued from page 16

21 Proposed reg. §1.956-4(c)(2).22 See supra, Section V, Part B.23 the preamble to the New Proposed regula-

tions states that the “treasury department and the irS have considered various methods for determining a partner’s share of a partnership obligation, including the regulations under section 752 for determining a partner’s share of partnership liabilities, the partner’s liquida-tion value percentage (discussed in Part 3 of

this preamble), and the partner’s interest in partnership profits. using the partner’s interest in partnership profits to determine a partner’s share of a partnership obligation is consistent with the observation that, to the extent the proceeds of a partnership borrowing are used by the partnership to invest in profit-generating activities, partners in the partnership (including service partners with limited or no partner-ship capital) will benefit from the partnership obligation to the extent of their interests in the partnership profits.” in other words, the New Proposed regulations adopt the standard for partnership excess nonrecourse liabilities. See reg. §1.752-3(a)(3) (“the partner’s share

of the excess nonrecourse liabilities … of the partnership as determined in accordance with the partner’s share of partnership profits. the partner’s interest in partnership profits is determined by taking into account all facts and circumstances relating to the economic arrangement of the partners”).

24 See Notice of Proposed rulemaking, Fr Vol. 79, No. 20, p. 4826 (Jan. 30, 2014); richard m. lipton, Proposed Regulations on Debt Alloca-tions: Controversial, and Deservedly So, 120 J. tax. 156 (2014).

25 See Proposed reg. §1.752-3(a)(3).26 Notice of Proposed rulemaking, 80 Fr Vol. 80,

No. 170, p. 53058 (Sept. 2, 2015).


75 reg. §1.1441-2(e)(8)(ii).76 reg. §1.871-15(i)(3)(i).77 reg. §1.1441-2(e)(8)(ii)(B).78 reg. §1.871-15(j)(2).79 See, e.g., international Swaps and derivatives

Association, inc. (iSdA), 2010 Short Form hire Act Protocol (Nov. 30, 2010), available online at www.isda.org/isda2010shortformhireact-prot/shortformhireactprot.html.

80 reg. §1.871-15(n)(1).81 reg. §1.871-15(n)(2).82 reg. §1.871-15(n)(3)(i).83 reg. §1.871-15(n)(3)(ii). Short-party brokers

may (but are not required to) assume that all transactions were entered into at 4:00 p.m. reg. §1.871-15(n)(5)(i).

84 reg. §1.871-15(p)(1). the new regulations pro-vide only that a short-party broker that satisfies the conditions is entitled to a “presumption” and is not required to exercise reasonable diligence. it is unclear whether the irS could rebut the presumption by proving that the short-party broker should have known (with-out exercising any diligence) that two or more transactions were entered into in connection with each other. For example, assume that a long party enters into 10 transactions with a short-party broker that satisfy the conditions for a presumption. however, the short-party broker has actual knowledge that nine of the transactions were entered into in connection with other transactions that cause them to be subject to withholding under Code Sec. 871(m). the short-party broker has no actual knowledge with respect to the tenth. if the short-party broker does not withhold on the tenth, may the irS rebut the presumption and impose withholding liability on the short-party broker?

85 reg. §1.871-15(n)(5)(ii).86 reg. §1.871-15(n)(4).87 reg. §1.871-15(n)(4).88 reg. §1.871-15(n)(5)(i).89 reg. §1.871-15(m)(1).90 reg. §1.871-15(m)(1).91 reg. §1.871-15(m)(2)(i).92 reg. §1.871-15(m)(2)(ii). Short parties, which

are responsible for withholding under Code Sec. 871(m), will want foreign long parties to represent that they have no such knowledge.

93 reg. §1.871-15(l)(2). this rule interprets Code Sec. 871(m)(4)(C), which provides that “an index or fixed basket of securities shall be treated as a single security.”

94 reg. §1.871-15(l)(1).95 reg. §1.871-15(l)(2).96 reg. §1.871-15(l)(3).97 the irS has determined that eurex deutschland

(Germany), the london international Financial Futures and options exchange, iCe Futures Canada, the dubai mercantile exchange, iCe Futures, mercantile division of the montreal exchange and international Futures exchange (Bermuda) are qualified boards of trade.

98 these include the CrSP total Stock market index (referenced by Vanguard total Stock

unrelated changes in the value of the debt instrument or other derivative. temporary reg. §1.871-15t(h)(1).

55 temporary reg. §1.871-15t(h)(1).56 reg. §1.871-15(i)(1).57 reg. §1.871-15(i)(2)(ii).58 there is always some risk that a corporation

will not pay a declared dividend. For example, in 2010, British Petroleum canceled a dividend that it had declared before the deepwater horizon oil spill in the Gulf of mexico. See American Bar Association Section of taxation, Comments on Proposed Regulations Issued under Section 871(m), at 20, fn. 43 (oct. 17, 2014), available online at www.americanbar.org/content/dam/aba/administrative/taxa-tion/policy/101714comments.authcheckdam.pdf. But there arguably is a period of days or weeks leading up to an ex-dividend date during which the risk of nonpayment is immaterial.

59 Code Sec. 871(m)(2)(B).60 deemed dividends under Code Sec. 305(b) and

(c) are distinguishable because a change in the conversion ratio of convertible debt and other transactions described in Code Sec. 305(b) and (c) have the economic effect of a dividend to the stockholder.

61 See, e.g., united States model income tax Convention, Article 24 (Nov. 15, 2006).

62 taxing noneconomic amounts is materially different from taxing original issue discount, mark-to-market gains, subpart F income or deemed dividends, which represent accretions to wealth.

63 reg. §1.871-15(i)(2)(iii).64 reg. §1.871-15(i)(2)(iii).65 reg. §1.871-15(i)(2)(iii). By contrast, under

the 2013 proposed regulations, the long party would have been deemed to receive the lesser of the actual and estimated dividends.

66 reg. §1.871-15(j)(1)(ii).67 reg. §1.871-15(i)(2)(iii).68 reg. §1.871-15(i)(2)(iv).69 reg. §1.871-15(i)(2)(i).70 reg. §1.871-15(j)(3).71 reg. §1.871-15(g)(2). By contrast, under the

2013 proposed regulations, the delta of a long-term derivative would have been calculated at the earlier of the stock’s ex-dividend date and the record date of the dividend, and the delta of a short-term derivative would have been calculated when the foreigner disposed of the derivative. under these rules, foreigners would not have been subject to withholding on short-term options that they allowed to lapse since the 2013 proposed regulations also provided that the delta of a short-term option at lapse was zero.

72 reg. §1.871-15(j)(1)(iii).73 reg. §1.1441-2(e)(8)(i).74 reg. §1.1441-2(e)(8)(iii).

Equity DerivativesContinued from page 28

market etF, which has more than $52.5 billion of assets under management), the mSCi uS Prime market Growth index (referenced by Vanguard Growth etF, which has more than $18.7 billion of assets under management), the Financial Select Sector index (referenced by State Street Financial Select Sector SPdr etF, which has more than $17.7 billion of assets under management) and dozens more.

99 reg. §1.871-15(l)(4).100 See mSCi World index Fact Sheet, available

online at www.msci.com/resources/factsheets/index_fact_sheet/msci-world-index.pdf (as of Aug. 31, 2015, u.S. stock represented 57.96 percent).

101 See rev. rul. 82-11, 1982-1 CB 51.102 See New York State Bar Association tax Sec-

tion, Report on Proposed Regulations under Section 871(m), at 30 (may 20, 2014) (“it would appear as a pure policy matter that this would be an appropriate application of section 871(m). however, we understand that due bills are a fairly common occurrence with respect to exchange-traded stock, and we are not familiar with the mechanics of these procedures, so we are concerned that requiring withholding in these circumstances could have an adverse impact on the orderly functioning of the exchanges.”), available online at www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2014/Tax_Section_Report_1306.html; American Bar Association Section of taxation, Comments on Proposed Regulations Issued under Section 871(m), at 12 (oct. 17, 2014) (“Although the payment under a due bill would appear to fall within the scope of a divi-dend equivalent, it is unclear to us whether the frequency of due bills with respect to publicly traded equities may mean that treating them as dividend equivalents would impede the orderly functioning of the capital markets.”), available online at www.americanbar.org/content/dam/aba/administrative/taxation/policy/101714comments.authcheckdam.pdf.

103 reg. §1.871-15(k).104 See New York State Bar Association tax Sec-

tion, Report on Proposed Regulations under Section 871(m), at 45 (may 20, 2014), avail-able online at www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2014/Tax_Section_Report_1306.html.

105 reg. §1.871-15(c)(2)(ii).106 temporary reg. §1.871-15t(c)(2)(iv)(A).107 temporary reg. §1.871-15t(c)(2)(iv)(B).108 reg. §1.871-15(c)(2)(v).109 A broker’s application of the presumption rules

described above in Part iii.F.2. to determine whether to combine transactions in making this determination does not violate the “rea-sonable diligence” standard.

110 reg. §1.871-15(p)(1).111 temporary reg. §1.1441-1t(e)(6).112 temporary reg. §1.1441-1t(e)(6)(ii).113 temporary reg. §1.1441-1t(e)(6)(i).114 reg. §1.871-15(o).


Regulations for TransfersContinued from page 30

Reg. §1.482-7 cost-sharing regula-tions to controlled transactions involving partnerships. Specifically, the Notice states that regulations will be issued applying the methods specified in Reg. §1.482-7(g), as adjusted to take into account the differences between partnerships and cost-sharing arrangements. Additionally, the Notice states that the regulations will provide periodic adjustment rules that are based on the principles of §1.482-7(i)(6), so that in the event of a trigger based on a significant divergence of actual returns from projected returns, the IRS may make periodic adjust-ments under a method based on Reg. §1.482-7(i)(6)(v), as well as any necessary corresponding adjust-ments to Code Sec. 704(b) or Code Sec. 704(c) allocations.

The Notice states in its “Reasons For Exercising Regulatory Author-ity” that an example it is concerned about is where a domestic partner receives a fixed preferred interest in exchange for the contribution of an intangible asset that is assigned a value that is inappropriately low, while a related foreign partner is specially allocated a greater share of the income from the intangible asset.

The Notice appears to take the position that a taxpayer who con-tributes intangible property and elects the gain deferral method and therefore the application of the remedial allocation method could still be subject to further adjust-ments in excess of its built-in gain amount. The Notice states that when intangible property is contributed to a partnership, the IRS may con-sider making periodic adjustments under Reg. §1.482-4(f )(2) in years

subsequent to the contribution, without regard to whether the tax year of the original transfer remains open for statute of limitations pur-poses. It states that the IRS may do so regardless of whether Code Sec. 721(a) applies to the initial contri-bution of intangible property to the partnership. Therefore, in the IRS’s view, even if a taxpayer elects the gain deferral method, it still would be subject to adjustments under Code Sec. 482 even though Code Sec. 721(a) applies.

Of course, any new rules that the IRS writes in this regard would need to be consistent with the arm’s-length standard, which underlies all of Code Sec. 482.3

The Notice reiterates the applica-tion of Code Sec.482 to controlled transactions involving partnerships under existing law.4 The Notice states that examples of the application of Code Sec. 482 under current law include adjustments to the amounts of contributions to and distributions from a partnership; partnership allo-cations, including allocations under Code Sec.704(c); and the relative magnitudes of the partners’ partner-ship interests in light of their respec-tive contributions and the related controlled transactions.

The Notice also states that the IRS can impute terms to a partnership agreement that are consistent with the substance of a transaction, for example, when a partner provides services to the partnership, but neither the partnership agreement nor any other agreement reflects the provision of such services. Fur-ther, according to the Notice, the IRS can apply an aggregate analysis under Reg. §1.482-1(f )(2)(i) to the extent that controlled transactions involving a partnership, including contributions of tangible and intan-gible property and the provision of

services by the controlled partners or their affiliates, are interrelated if the aggregate analysis provides the most reliable means of determin-ing the arm’s-length results for the controlled transactions.

Finally, the Notice also states that Treasury and the IRS are consider-ing issuing regulations under Reg. §1.6662-6(d) to require additional documentation for certain controlled transactions involving partnerships. These regulations may require, for ex-ample, documentation of projected returns for property contributed to a partnership (as well as attributable to related controlled transactions) and of projected partnership alloca-tions, including projected remedial allocations covered, for a specified number of years.

Effective DatesIn respect of the gain deferral method, the Notice is generally applicable to transfers occurring on or after August 6, 2015, and to transfers occurring before August 6, 2015, resulting from entity classification elections made under Reg. §301.7701-3 that are filed on or after August 6, 2015, and that are effective on or before August 6, 2015. Reporting require-ments in respect of the gain deferral method are effective on or after the publication date of regulations.

New rules under Code Sec. 482 would be effective for transfers and controlled transactions occurring on or after the date of publication date of regulations.

EndnotEs* this article is reprinted from J. Passthrough

entities, Nov.-dec. 2015 at 21.1 Notice 2015-54, irB 2015-34, 10.2 See also reg. §1.704-3(d)(7), example 1.3 See, e.g., reg. §1.482-1(b); Xilinx, Inc., CA-9,

2010-1 ustc ¶50,302, 598 F3d 1191 (2010).4 See reg. §§1.704-1(b)(1)(iii), -1(b)(5), example

28 in this regard.

http://CCHGroup.com/JournalApps