[Federal Register Volume 66, Number 11 (Wednesday, January 17, 2001)]
[Proposed Rules]
[Pages 3920-3924]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-270]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-104876-00]
RIN 1545-AY66


Taxable Years of Partner and Partnership; Foreign Partners

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations on the taxable 
year of a partnership with foreign partners. The proposed regulations 
affect partnerships and their partners. This document also contains a 
notice of public hearing on these proposed regulations.

DATES: Written comments must be received by April 17, 2001. Requests to 
speak (with outlines of oral comments) at the public hearing scheduled 
for June 6, 2001, at 10 a.m., must be submitted by May 16, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-104876-00), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered between the hours of 8 a.m. 
and 5 p.m. to: CC:M&SP:RU (REG-104876-00), Courier's Desk, Internal 
Revenue Service, 1111 Constitution Avenue NW., Washington, DC. 
Alternatively, taxpayers may submit comments electronically via the 
Internet by selecting the ``Tax Regs'' option of the IRS Home Page or 
by submitting comments directly to the IRS Internet site at http://
www.irs.ustreas.gov/tax__regs/regslist.html. The public hearing will be 
held in room 4718, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Dan 
Carmody, (202) 622-3080; concerning specific international issues, 
Ronald M. Gootzeit, (202) 622-3860; concerning submissions of comments, 
the hearing, and/or to be placed on the building access list to attend 
the hearing, LaNita VanDyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: This document proposes to amend section 706 
of the Income Tax Regulations (26 CFR part 1) regarding partnership 
taxable years.

Background

    Section 706 governs the taxable years for a partnership and its 
partners. The partners and the partnership each have their own taxable 
years, which may or may not coincide. Under section 706(a), for a 
partner's taxable year, the partner must include in taxable income the 
partner's share of any income, gain, loss, deduction, or credit of the 
partnership for the partnership's taxable year that ends within or with 
the partner's taxable year. Section 706(b) provides rules for 
determining a partnership's taxable year.
    Prior to the Tax Reform Act of 1986, it was possible for partners 
to create income deferral opportunities through arranging divergent 
taxable years for a partnership and its partners. For example, under 
certain circumstances, a partnership could elect a June 30 taxable year 
while its partners were calendar year taxpayers. Under such an 
arrangement, the partners would include partnership income earned from 
July 1, Year 1, to June 30, Year 2, in Year 2, when the partnership's 
taxable year ended, even though six months of income was generated 
during Year 1. To prevent this potential for income deferral, Congress 
amended section 706(b). See generally Staff of the Joint Committee on 
Taxation, General Explanation of the Tax Reform Act of 1986, 533-39 
(1986).
    Section 706(b) provides that, unless the partnership establishes a 
business purpose for a different taxable year, a partnership cannot 
have a taxable year other than: (i) the majority interest taxable year; 
(ii) if there is no majority interest taxable year, the taxable year of 
all the principal partners of the partnership; or (iii) if there is no 
taxable year described in (i) or (ii), the calendar year unless the 
Secretary by regulation prescribes another period. Section

[[Page 3921]]

1.706-1T(a)(1) and (2) provides that if neither (i) nor (ii) is 
applicable, the partnership's taxable year will be the taxable year 
that results in the least aggregate deferral of partnership income.
    Additionally, Sec. 1.706-3T(a) provides that under certain 
circumstances, a tax-exempt partner will be disregarded for purposes of 
section 706(b).

Explanation of Provisions

I. Treatment of Foreign Partners

    Currently, foreign partners are taken into consideration when 
determining a partnership's taxable year under section 706(b). In some 
circumstances, this could allow the taxable year of a partnership to be 
determined for Federal tax purposes by reference to the taxable year of 
one or more partners who may not be subject to U.S. taxation on income 
earned through the partnership. For instance, assume that a foreign 
partner owns a majority interest in a partnership that generates only 
foreign source income that is not effectively connected with a trade or 
business conducted within the United States. The minority partners are 
domestic persons subject to tax in the United States on income earned 
through the partnership. If the taxable year or years of the domestic 
partners are different from that of the majority partner, the majority 
partner's taxable year would determine the partnership's taxable year, 
which would affect the timing of the domestic partners' inclusion of 
partnership income. Thus, by conforming the partnership's taxable year 
to the taxable year of foreign partners, the mechanical application of 
section 706(b) can create deferral for those partners who are subject 
to tax in the United States on income earned through the partnership, 
while having no impact on the majority foreign partners who are not 
subject to tax in the United States on such income. The IRS and the 
Treasury do not believe that such a result is consistent with the 
intent of the statute.
A. Disregard Certain Foreign Partners
    The proposed regulations generally require foreign partners who are 
not subject to U.S. taxation on a net basis on income earned through 
the partnership to be disregarded for purposes of applying section 
706(b). For these purposes a foreign partner will be considered subject 
to Federal income tax only if the partner is allocated gross income of 
the partnership that is effectively connected (or treated as 
effectively connected) with the conduct of a trade or business within 
the United States (effectively connected income or ECI). In the case of 
a foreign partner claiming benefits under a U.S. income tax treaty, a 
foreign partner will be disregarded unless it is allocated gross income 
that is attributable to a permanent establishment in the United States.
    A foreign partner also may be subject to U.S. Federal income tax on 
its distributive share of fixed or determinable annual or periodic 
income (FDAP income) from U.S. sources. In certain circumstances, the 
timing for imposing United States withholding tax on FDAP income earned 
through a partnership may be affected by the partnership's taxable 
year. See, e.g., Sec. 1.1441-5(b)(2)(i) (providing the timing for 
withholding under section 1441 in the case of a domestic partnership 
that has received, but not distributed, FDAP income that is includible 
in the distributive share of a foreign partner). The IRS and Treasury 
believe that the withholding provisions of section 1441 provide a more 
appropriate mechanism than section 706 for addressing timing issues for 
these partners. Additionally, the IRS and Treasury are concerned that 
the ability of a partnership to earn small amounts of FDAP income, and 
thereby alter the determination of its taxable year, may permit 
inappropriate manipulation of the rule under section 706(b) for the 
domestic partners. Accordingly, under these proposed regulations, the 
taxable year of a foreign partner would be disregarded for purposes of 
section 706(b) if that partner is subject to Federal income tax solely 
due to the presence of U.S. source income earned through the 
partnership that is not ECI. In addition, it is irrelevant, for 
purposes of the proposed regulations, whether the foreign partner is 
subject to tax in the United States with respect to income other than 
income earned by the partnership.
    The rule for foreign partners provided in these proposed 
regulations generally is consistent with the present rule under 
Sec. 1.706-3T for the treatment of partners that are exempt from 
taxation under section 501(a). The taxable years of tax-exempt partners 
are not considered for purposes of section 706(b) unless those partners 
are subject to tax on income from the partnership. One difference 
between the rules for foreign partners and the rules for tax-exempt 
partners is that foreign partners will be included in determining a 
partnership's taxable year where the foreign partner is allocated gross 
income that is effectively connected with a U.S. trade or business, but 
actually has a net loss from the partnership for the taxable year 
(i.e., the foreign partners are not actually subject to tax on their 
allocable portion of the partnership's income). By contrast, a tax-
exempt partner is disregarded where its allocable share of the 
partnership's tax items produces a net loss for the taxable year even 
though, if the foreign partner were allocated net income for the 
taxable year, the tax-exempt entity would have been subject to tax on 
such income. The IRS and Treasury are considering modifying the tax-
exempt rule to conform with the proposed rule for foreign partners and 
request comments in this regard.
    Finally, for purposes of these rules, the proposed regulations 
generally define a foreign partner as a partner that is not a U.S. 
person (as defined in section 7701(a)(30)), but provide that controlled 
foreign corporations (CFCs) and foreign personal holding companies 
(FPHCs) are not treated as foreign partners. These entities are not 
treated as foreign for purposes of determining a partnership's taxable 
year under section 706 because the U.S. owners of such entities may be 
subject to Federal income taxation on a current basis with respect to 
income earned by the entities.
    The IRS and Treasury also considered, but did not include, a 
similar rule for passive foreign investment companies (PFICs). The 
proposed regulations do not include a similar rule for PFICs because, 
unlike the rules for CFCs and FPHCs, which require that a majority of 
the ownership be concentrated in a small group of U.S. persons, the 
PFIC rules apply without regard to the level of ownership of the 
individual, or of all U.S. owners in the aggregate. Additionally, in 
most instances where a PFIC does have substantial U.S. ownership, it 
will also be a CFC or a FPHC.
B. Minority Interest Rule
    The IRS and Treasury recognize that requiring a partnership taxable 
year to be determined without regard to certain foreign partners may 
present difficulties for minority partners in some cases. If the 
taxable years of certain foreign partners are disregarded for purposes 
of section 706(b), it is possible that the taxable year of a 
partnership may be determined solely by reference to the taxable year 
of one or more small minority domestic partners. This could create 
significant administrative burdens for minority partners if the 
partnership maintains its books and records on a taxable year selected 
by significant foreign partners that is different from the taxable year 
of the minority partner or partners.
    In order to provide relief in this situation, the proposed 
regulations contain an exception providing that foreign partners will 
not be disregarded

[[Page 3922]]

for purposes of section 706(b) if the partnership's taxable year would 
be determined by reference to partners that individually hold less than 
a 10-percent interest, and in the aggregate hold less than a 20-percent 
interest, in the capital and profits of the partnership. For purposes 
of this rule, a partner's interest will include interests held directly 
and interests held by related partners. In determining whether the 
minority interest rule applies, the proposed regulations take into 
account the ownership of tax-exempt entities that are disregarded under 
Sec. 1.706-3T(a).
    Where a domestic tax-exempt entity (or entities) owns a relatively 
small interest in the partnership, but enough to cause the minority 
interest rule not to apply, the result may be anomalous, given that the 
tax-exempt entity has no real interest in a particular taxable year and 
thus has no incentive to convince significant foreign partners to cause 
the partnership to determine its taxable year by reference to the 
domestic partners. However, where such a tax-exempt entity (or 
entities) owns a majority interest in the partnership, the result may 
be more appropriate because the domestic partners are more likely to 
have significant bargaining power regarding the taxable year vis-a-vis 
the foreign partners. An appropriate solution may be to exclude tax-
exempt entities from both the numerator and denominator in applying the 
de minimis rule. The IRS and Treasury request comments regarding how 
tax-exempt entities should be treated for purposes of the minority 
interest rule.
C. Transitional Relief
    Under current law, a partnership may have adopted a taxable year 
that creates deferral by reference to the taxable year of a foreign 
partner not subject to U.S. net income taxation. In such instances, 
compliance with these regulations could result in a change in the 
partnership taxable year which would cause a ``bunching'' of more than 
12 months of partnership income into a single taxable year of the 
partners subject to Federal income tax.
    For example, consider a partnership that has a June 30 taxable year 
because of the presence of a 60-percent foreign partner that is not 
subject to U.S. net income taxation on income earned through the 
partnership. This taxable year creates six months of deferral for the 
40-percent domestic partner, who is on the calendar year. In the year 
that these proposed regulations become effective, two partnership 
taxable years (the taxable year concluding on June 30 and the initial 
short calendar year concluding December 31) would close during the 
domestic partner's taxable year. Thus, section 706(a) would require the 
domestic partner to recognize its distributive share of 18 months of 
partnership income during a single taxable year. While the historic 
taxable year of the partnership in this example is inconsistent with 
the intent of section 706(b), the IRS and Treasury recognize that the 
potential bunching of income caused by changing to an appropriate 
taxable year might present an undue hardship for some taxpayers.
    In order to alleviate such a hardship, the proposed regulations 
would permit adversely affected taxpayers to apply the four-year spread 
provisions of Sec. 1.702-3T. This transitional rule will have limited 
application; it is intended only to provide relief for bunching of 
income that occurs in the first taxable year beginning on or after the 
effective date of these proposed regulations.

II. Application of Sec. 1.701-2

    The mechanical rules of section 706(b) operate to limit partners' 
opportunities to defer the recognition of partnership income. Where 
partners have different taxable years, eliminating or limiting deferral 
for one partner may result in increasing deferral for another partner. 
Such deferral is an anticipated result of section 706(b). However, an 
application of the mechanical rules of section 706(b) and these 
proposed regulations remains subject to the anti-abuse rule of 
Sec. 1.701-2.
    For example, assume that these proposed regulations would disregard 
the taxable year of a 76-percent foreign partner and require the 
partnership (which only has foreign operations, and therefore does not 
earn ECI) to adopt the taxable year of the 24-percent domestic partner. 
Conceivably the partners could attempt to avoid this result by forming 
a tiered structure where the foreign partner would own a 95-percent 
interest in an upper-tier domestic partnership that would hold, as its 
only asset, an 80 percent interest in the lower-tier operating 
partnership (the domestic partner would own the remaining 5 percent of 
the upper-tier partnership and the remaining 20 percent of the lower-
tier partnership). In substance, this is the same arrangement as the 
single partnership except that the minority interest rule would 
generally require the upper-tier partnership to adopt the taxable year 
of the foreign partner (because the domestic partner owns less than a 
10-percent interest in the upper-tier partnership). The upper-tier 
domestic partnership's taxable year would then be considered the 
majority interest taxable year of the lower-tier partnership under 
section 706(b)(1)(B)(i). In these circumstances, the Commissioner may 
determine that in order to achieve a tax result that is consistent with 
the intent of section 706, Sec. 1.701-2 should apply. In such event, 
the Commissioner may disregard the upper-tier partnership and treat the 
assets thereof (in this case, the interest in the lower-tier 
partnership) as being owned directly by its partners, with the result 
that the foreign partner would be disregarded in determining the 
taxable year of the lower-tier partnership under section 706(b) and 
these proposed regulations.

III. Finalization of Prior Proposed Regulations

    The current temporary regulations under section 706 are the product 
of three separate Treasury decisions. The text of these Treasury 
decisions, TD 7991 (adopted November 29, 1984), TD 8169 (adopted 
December 23, 1987), and TD 8205 (adopted May 24, 1988), were also 
contemporaneously promulgated as proposed regulations, LR-183-84 
(published in the Federal Register on November 30, 1984), LR-101-86 
(published in the Federal Register on December 29, 1987), and LR-53-880 
(published in the Federal Register on May 27, 1988). These proposed 
regulations have not been withdrawn, and it is likely that they will be 
finalized in conjunction with the finalization of the regulations 
proposed by this document. The IRS and Treasury expect that the 
finalization of these previously proposed regulations will be 
accompanied by the withdrawal of the existing temporary regulations. 
Comments previously received in connection with the prior proposed 
regulations will be considered as well as new or additional comments 
with respect to such regulations.

IV. Effective Date

    These regulations are proposed to apply to partnership taxable 
years beginning on or after the date final regulations are published in 
the Federal Register. For example, if the final regulations were 
published on November 1, 2001, a partnership that historically has 
determined its taxable year by reference to a 75-percent foreign 
partner with a March 31 taxable year end rather than by reference to a 
25-percent domestic partner that uses the calendar year would be 
required to change to the calendar year as of April 1, 2002 (the 
partnership year beginning after the date final regulations were 
published). This would result in a short taxable year from April 1, 
2002, to December 31, 2002.

[[Page 3923]]

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
these regulations do not impose on small entities a collection of 
information requirement, the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis 
is not required. Pursuant to section 7805(f) of the Internal Revenue 
Code, this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (preferably a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and Treasury specifically request comments on the clarity 
of the proposed regulations and how they may be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for June 6, 2001, beginning at 
10 a.m., in room 4718, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Due to building security procedures, 
visitors must enter at the 10th Street entrance, located between 
Constitution and Pennsylvania Avenues, NW. In addition, all visitors 
must present photo identification to enter the building. Because of 
access restrictions, visitors will not be admitted beyond the immediate 
entrance area more than 15 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons 
that wish to present oral comments at the hearing must submit timely 
written comments and must submit an outline of the topics to be 
discussed and the time to be devoted to each topic (preferably a signed 
original and eight (8) copies) by May 16, 2001.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Dan Carmody, Office of 
Chief Counsel (Passthroughs and Special Industries). However, other 
personnel from the IRS and Treasury Department participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.706-4 is added to read as follows:


Sec. 1.706-4  Certain foreign partners disregarded.

    (a) General rule--(1) Foreign partners not claiming benefits under 
a U.S. income tax treaty. In determining the taxable year (the current 
taxable year) of a partnership under section 706(b) and the regulations 
thereunder, a foreign partner shall be disregarded unless such partner 
is allocated any gross income of the partnership that was effectively 
connected (or treated as effectively connected) with the conduct of a 
trade or business within the United States during the partnership's 
taxable year immediately preceding the current taxable year. However, 
if a foreign partner was not a partner during the partnership's 
immediately preceding taxable year, such partner will be disregarded 
for the current taxable year if the partnership reasonably believes 
that the partner will not be allocated any gross income generated by 
the partnership during the current taxable year that is effectively 
connected with the conduct of a trade or business within the United 
States.
    (2) Foreign partners claiming benefits under a U.S. income tax 
treaty. In the case of a foreign partner claiming benefits under an 
income tax treaty between the United States and another jurisdiction, a 
foreign partner will be disregarded under this paragraph (a) unless 
such partner was allocated any gross income that was attributable to a 
permanent establishment in the United States during the partnership's 
taxable year immediately preceding the current taxable year (or, if 
such partner was not a partner during the immediately preceding taxable 
year, the partnership reasonably believes that such partner will be 
allocated such income during the current taxable year).
    (b) Minority interest rule. If the partners that are not 
disregarded by paragraph (a) of this section (absent the application of 
this paragraph (b)) individually hold less than a 10-percent interest, 
and in the aggregate hold less than a 20-percent interest, in the 
capital and profits of the partnership, paragraph (a) of this section 
will not apply. For purposes of determining ownership in the 
partnership after application of paragraph (a) of this section, the 
constructive ownership rules of section 318 shall apply, and the 
attribution rules of section 267(c) also shall apply to the extent they 
attribute ownership to persons to whom section 318 does not attribute 
ownership. However, ``10 percent'' shall be substituted for ``50 
percent'' in section 318(a)(2)(C) and (3)(C). For purposes of 
determining if partners hold less than a 20-percent interest in the 
aggregate, the same interests will not be considered as being owned by 
more than one partner.
    (c) Definition of foreign partner. For purposes of this section, a 
foreign partner is any partner that is not a U.S. person (as defined in 
section 7701(a)(30)), except that a partner that is a controlled 
foreign corporation (as defined in section 957(a)) or a foreign 
personal holding company (as defined in section 552) shall not be 
treated as a foreign partner.
    (d) Example. The provisions of this section may be illustrated by 
the following example:

    Example. Partnership B is owned by two partners, F, a foreign 
corporation that owns a 95-percent interest in the capital and 
profits of partnership B, and D, a domestic corporation that owns 
the remaining 5-percent interest in the capital and profits of 
partnership B. Partnership B is not engaged in the conduct of a 
trade or business within the United States, and, accordingly, 
partnership B does not earn any income that is effectively connected 
with a U.S. trade or business. F uses a March 31 fiscal year, and 
causes partnership B to maintain its books and records on a March 31 
fiscal year as well. D is a calendar year taxpayer. Under paragraph 
(a) of this section, F would be disregarded and partnership B's 
taxable year would be determined by reference to D. However, because 
D owns less than a 10-percent interest in the capital and profits of 
partnership B, the minority interest rule of paragraph (b) of this 
section applies, and

[[Page 3924]]

partnership B must adopt the March 31 fiscal year.

    (e) Effective date--(1) Generally. The provisions of this section 
are applicable for partnership taxable years that begin on or after the 
date final regulations are published in the Federal Register.
    (2) Transition rule. Partners of a partnership that is required to 
change its taxable year as of the beginning of its first taxable year 
after the date final regulations are published in the Federal Register 
may apply the provisions of Sec. 1.702-3T if the change in taxable year 
occurs in the first taxable year following the date final regulations 
are published in the Federal Register.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 01-270 Filed 1-16-01; 8:45 am]
BILLING CODE 4830-01-P