[Federal Register Volume 67, Number 141 (Tuesday, July 23, 2002)]
[Rules and Regulations]
[Pages 48017-48020]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-18455]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9009]
RIN 1545-AY66


Taxable Years of Partner and Partnership; Foreign Partners

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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SUMMARY: This document contains final regulations on the taxable year 
of a partnership with foreign partners and tax-exempt partners. The 
final regulations provide that in certain circumstances the taxable 
year of a partnership will be determined without regard to the taxable 
year of certain foreign partners and certain tax-exempt partners.

DATES: Effective Date: These regulations are effective on July 23, 
2002.
    Applicability Date: For dates of applicability of these 
regulations, see Secs. 1.706-1(b)(5)(iii), (b)(6)(v), and (b)(11)(ii).

FOR FURTHER INFORMATION CONTACT: Dan Carmody, (202) 622-3080 (not a 
toll-free number). For specific information regarding international 
issues, contact Ronald M. Gootzeit, (202) 622-3860 (not a toll-free 
number).

SUPPLEMENTARY INFORMATION:

Introduction

    This document finalizes portions of Sec. 1.706-1(b) of the Income 
Tax Regulations (26 CFR part 1) relating to the determination of the 
taxable year of a partnership with tax-exempt partners and foreign 
partners. This document also withdraws Sec. 1.706-3T (26 CFR part 1).

Background

    On May 24, 1988, Treasury and the Internal Revenue Service (IRS) 
issued temporary regulations (Sec. 1.706-3T, promulgated as part of TD 
8205 (53 FR 19688)) with a contemporaneous notice of proposed 
rulemaking (LR-53-88 (53 FR 19715)) relating to the determination of 
the taxable year of a partnership with tax-exempt partners (the 1988 
Proposed Regulations). On January 17, 2001, Treasury and the IRS 
published in the Federal Register a notice of proposed rulemaking [REG-
104876-00 (66 FR 3920)] to provide guidance relating to the 
determination of the taxable year of a partnership with foreign 
partners (the 2001 Proposed Regulations). In that notice of proposed 
rulemaking, Treasury and the IRS also indicated that the 1988 Proposed 
Regulations would be finalized. A public hearing was held on June 6, 
2001. After consideration of the comments, the proposed regulations are 
adopted as revised by this Treasury decision.

Explanation of Revisions and Summary of Comments

I. In General

    Section 706 provides rules relating to the taxable years of a 
partnership and its partners. Under section 706(a), in computing the 
taxable income of a partner for a taxable year, the partner must 
include 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)(1)(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 1.706-1(b)(2) of the Income Tax Regulations 
provides that, if neither section 706(b)(1)(B)(i) nor (ii) apply, the 
partnership's taxable year will be the taxable year that results in the 
least aggregate deferral of partnership income.
    As part of a larger guidance project on accounting periods, the 
regulations under section 706 were restructured on May 17, 2002 [TD 
8996 (67 FR 35009)]. To conform with the restructuring, the regulations 
finalized by this document will be finalized as amendments to 
Sec. 1.706-1 even though they were proposed under Secs. 1.706-3 and 
1.706-4. A small portion of the proposed regulation under Sec. 1.706-3 
dealing with the effect of partner elections under

[[Page 48018]]

section 444 has been finalized as Sec. 1.706-1(b)(11).

II. Treatment of Tax-Exempt Partners

    The 1988 Proposed Regulations provide that, in determining the 
taxable year (the current year) of a partnership under section 706(b) 
and the regulations thereunder, a partner that is tax-exempt under 
section 501(a) is disregarded if such partner was not subject to tax, 
under chapter 1 of the Internal Revenue Code (Code), on any income 
attributable to its investment in the partnership during the 
partnership's taxable year immediately preceding the current year. This 
Treasury decision finalizes the 1988 Proposed Regulations without 
substantive change and withdraws the temporary regulations.

III. Treatment of Foreign Partners

A. General Rule
    The 2001 Proposed Regulations generally provide that a foreign 
partner that is not subject to U.S. taxation on a net basis on income 
earned through the partnership is disregarded for purposes of section 
706(b). For these purposes, a foreign partner will be considered 
subject to U.S. taxation on a net basis 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, such partner is disregarded unless it is allocated 
any gross income that is attributable to a permanent establishment in 
the United States.
    The final regulations follow the same approach as the proposed 
regulations, but the general rule has been clarified to provide that a 
foreign partner is disregarded unless such partner is allocated any 
gross income that is ECI, and the taxation of the income is not 
otherwise precluded under any U.S. income tax treaty. Gross income for 
these purposes does not include income that is excluded under another 
Code provision (e.g., the exclusion from gross income under section 883 
for certain transportation income). Further, as the preamble to the 
proposed regulations [REG-104876-00 (66 FR 3920, 3922)] states, the 
Commissioner may challenge an arrangement that, while conforming to 
these rules, is undertaken with a principal purpose of achieving a tax 
result that is inconsistent with the intent of section 706. Sec. 1.701-
2.
    A commentator questioned the statutory authority for regulations 
that disregard the interest in a partnership held by certain foreign 
partners in determining a partnership's taxable year under section 
706(b). Treasury and the IRS believe that they have the authority to 
adopt these final regulations in order to resolve ambiguity in the 
statutory provisions in a manner that is consistent with the objectives 
of section 706(b) to eliminate or reduce the amount of deferral 
available on income earned through a partnership.
B. Application of the Minority Interest Rule
    Treasury and the IRS 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. For this 
reason, the proposed regulations include a ``minority interest rule'' 
which provides that the taxable years of foreign partners are not 
disregarded for purposes of section 706(b) if no single partner (other 
than a disregarded foreign partner) holds a 10-percent or greater 
interest in the capital or profits of the partnership, and if, in the 
aggregate, the partners that are not disregarded foreign partners do 
not hold a 20-percent or greater interest in the capital or profits of 
the partnership.
    The 2001 Proposed Regulations provide that, for purposes of 
determining a partner's ownership in the partnership, the constructive 
ownership rules of section 318 apply (substituting ``10 percent'' for 
``50 percent'' in section 318(a)(2)(C) and (3)(C)) and the attribution 
rules of section 267(c) also apply to the extent that those rules 
attribute ownership to persons to whom section 318 does not attribute 
ownership. These regulations replace this attribution rule with an 
attribution rule based on the principles of sections 267(b) and 707(b). 
Attribution under sections 267(b) and 707(b) is more commonly applied 
in the partnership context than is attribution under section 318, which 
is generally used to determine constructive ownership of stock.
    Commentators expressed concern that the 10- and 20-percent 
thresholds were too low. They explained that U.S. minority partners 
would have difficulty reporting partnership income timely under these 
rules, because a U.S. minority partner typically lacks the practical or 
legal ability to cause a foreign partnership to close its books and 
conduct a mid-year accounting. Treasury and the IRS believe that 
partners can generally negotiate with the partnership to obtain the 
information needed to comply with their reporting obligations under 
these regulations. Recognizing, though, that partners in existing 
partnerships may not be in a position to renegotiate for partnership 
information, Treasury and the IRS have made these regulations 
applicable on a mandatory basis only to partnerships formed on or after 
September 23, 2002. Partnerships formed before September 23, 2002, 
however, may elect to change their taxable years to conform with these 
regulations. Such a change will be treated as a change to a required 
taxable year under Sec. 4 of Rev. Proc. 2002-38 (2002-22 I.R.B. 1), or 
any successor, and the partnership will then be subject to the 
requirements of Sec. 1.706-1(b)(6). Moreover, if an existing 
partnership terminates under the rules of section 708(b)(1)(B), the 
resulting partnership will be subject to the requirements of these 
regulations. Treasury and the IRS request comments on additional ways 
in which the administrative burdens associated with these regulations 
may be reduced.
    The preamble to the 2001 Proposed Regulations requests comments on 
whether tax-exempt partners should be excluded for purposes of the 
minority interest rule. As no comments were received, the final 
regulations consider tax-exempt partners in determining whether the 
minority interest rule applies.

IV. Effective Date

    The regulations under Sec. 1.706-1(b)(5) relating to the taxable 
year of a partnership with tax-exempt partners apply to taxable years 
beginning on or after July 23, 2002. For taxable years beginning before 
July 23, 2002, see Sec. 1.706-3T as contained in 26 CFR part 1 revised 
April 1, 2002.
    The regulations under Sec. 1.706-1(b)(6) relating to the taxable 
year of a partnership with foreign partners are applicable for taxable 
years of partnerships (other than existing partnerships as defined in 
Sec. 1.706-1(b)(6)(v)) beginning on or after July 23, 2002.
    The regulations under Sec. 1.706-1(b)(11) relating to the effect of 
partner elections under section 444 are applicable for taxable years of 
partnerships beginning on or after July 23, 2002. For taxable years 
beginning before July 23, 2002, see Sec. 1.706-3T as contained in 26 
CFR part 1 revised April 1, 2002.

V. Transitional Relief for Existing Partnerships With Foreign Partners

    The 2001 Proposed Regulations recognize that a potential hardship 
exists for partners of an existing partnership that changes its taxable 
year to comply with Sec. 1.706-1(b)(6). If the

[[Page 48019]]

change results in two partnership taxable years ending within a 
partner's single taxable year, that partner could experience a bunching 
of more than 12 months of partnership income in a single taxable year. 
In order to avoid potential hardships, the 2001 Proposed Regulations 
incorporate the transitional rules of Sec. 1.702-3T to allow the gain 
recognition to be spread over a four-year period. A partnership that 
uses this transitional rule is required to take into account all items 
of income, gain, loss, deduction and credit ratably over the four-year 
period.
    Unlike the 2001 Proposed Regulations, these regulations do not 
require that existing partnerships change their taxable years to 
conform to the regulations. Because the regulations do not require 
existing partnerships to change their taxable years, the need for 
transitional relief is less imperative. Nevertheless, to encourage 
existing partnerships to change their taxable years to conform to these 
regulations, Treasury and the IRS have retained the transitional rule 
for any partnership that elects to apply the regulations in its first 
taxable year beginning on or after July 23, 2002.

Special Analyses

    It has been determined that this Treasury decision 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) and the Regulatory Flexibility Act (5 U.S.C. chapter 
6) do not apply to these regulations and, therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Code, the notice of proposed rulemaking preceding these regulations 
was submitted to the Small Business Administration for comment on its 
impact on small business.

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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


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

    2. In Sec. 1.706-1, paragraphs (b)(5) and (b)(6) are revised and 
paragraph (b)(11) is added to read as follows:


Sec. 1.706-1  Taxable years of partner and partnership.

* * * * *
    (b) * * *
    (5) Taxable year of a partnership with tax-exempt partners--(i) 
Certain tax-exempt partners disregarded. In determining the taxable 
year (the current year) of a partnership under section 706(b) and the 
regulations thereunder, a partner that is tax-exempt under section 
501(a) shall be disregarded if such partner was not subject to tax, 
under chapter 1 of the Internal Revenue Code, on any income 
attributable to its investment in the partnership during the 
partnership's taxable year immediately preceding the current year. 
However, if a partner that is tax-exempt under section 501(a) was not a 
partner during the partnership's immediately preceding taxable year, 
such partner will be disregarded for the current year if the 
partnership reasonably believes that the partner will not be subject to 
tax, under chapter 1 of the Internal Revenue Code, on any income 
attributable to such partner's investment in the partnership during the 
current year.
    (ii) Example. The provisions of paragraph (b)(5)(i) of this section 
may be illustrated by the following example:

    Example. Assume that partnership A has historically used the 
calendar year as its taxable year. In addition, assume that A is 
owned by 5 partners, 4 calendar year individuals (each owning 10 
percent of A's profits and capital) and a tax-exempt organization 
(owning 60 percent of A's profits and capital). The tax-exempt 
organization has never had unrelated business taxable income with 
respect to A and has historically used a June 30 fiscal year. 
Finally, assume that A desires to retain the calendar year for its 
taxable year beginning January 1, 2003. Under these facts and but 
for the special rule in paragraph (b)(5)(i) of this section, A would 
be required under section 706(b)(1)(B)(i) to change to a year ending 
June 30, for its taxable year beginning January 1, 2003. However, 
under the special rule provided in paragraph (b)(5)(i) of this 
section the partner that is tax-exempt is disregarded, and A must 
retain the calendar year, under section 706(b)(1)(B)(i), for its 
taxable year beginning January 1.

    (iii) Effective date. The provisions of this paragraph (b)(5) are 
applicable for taxable years beginning on or after July 23, 2002. For 
taxable years beginning before July 23, 2002, see Sec. 1.706-3T as 
contained in 26 CFR part 1 revised April 1, 2002.
    (6) Certain foreign partners disregarded--(i) Interests of 
disregarded foreign partners not taken into account. In determining the 
taxable year (the current taxable year) of a partnership under section 
706(b) and the regulations thereunder, any interest held by a 
disregarded foreign partner is not taken into account. A foreign 
partner is a disregarded foreign partner 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 (or, if 
such partner was not a partner during the partnership's immediately 
preceding taxable year, the partnership reasonably believes that the 
partner will be allocated any such income during the current taxable 
year) and taxation of that income is not otherwise precluded under any 
U.S. income tax treaty.
    (ii) Definition of foreign partner. For purposes of this paragraph 
(b)(6), 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.
    (iii) Minority interest rule. If each partner that is not a 
disregarded foreign partner under paragraph (b)(6)(i) of this section 
(regarded partner) holds less than a 10-percent interest, and the 
regarded partners, in the aggregate, hold less than a 20-percent 
interest in the capital or profits of the partnership, then paragraph 
(b)(6)(i) of this section does not apply. In determining ownership in a 
partnership for purposes of this paragraph (b)(6)(iii), each regarded 
partner is treated as owning any interest in the partnership owned by a 
related partner. For this purpose, partners are treated as related if 
they are related within the meaning of sections 267(b) or 707(b) (using 
the language ``10 percent'' instead of ``50 percent'' each place it 
appears). However, 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 regarded partner.
    (iv) Example. The provisions of paragraph (b)(6) of this section 
may be illustrated by the following example:


[[Page 48020]]


    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 
(b)(6)(i) 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)(6)(iii) of this section applies, and partnership B must adopt 
the March 31 fiscal year for Federal tax purposes.

    (v) Effective date--(A) Generally. The provisions of this paragraph 
(b)(6) are applicable for the first taxable year of a partnership other 
than an existing partnership that begins on or after July 23, 2002. For 
this purpose, an existing partnership is a partnership that was formed 
prior to September 23, 2002.
    (B) Voluntary change in taxable year. An existing partnership may 
change its taxable year to a year determined in accordance with this 
section. An existing partnership that makes such a change will cease to 
be exempted from the requirements of paragraph (b)(6) of this section.
    (C) Subsequent sale or exchange of interests. If an existing 
partnership terminates under section 708(b)(1)(B), the resulting 
partnership is not an existing partnership for purposes of paragraph 
(b)(6)(v)(A) of this section.
    (D) Transition rule. If, in the first taxable year beginning on or 
after July 23, 2002, an existing partnership voluntarily changes its 
taxable year to a year determined in accordance with this paragraph 
(b)(6), then the partners of that partnership may apply the provisions 
of Sec. 1.702-3T to take into account all items of income, gain, loss, 
deduction, and credit attributable to the partnership year of change 
ratably over a four-year period.
* * * * *
    (11) Effect of partner elections under section 444--(i) Election 
taken into account. For purposes of section 706(b)(1)(B), any section 
444 election by a partner in a partnership shall be taken into account 
in determining the taxable year of the partnership. See Sec. 1.7519-
1T(d), Example (4).
    (ii) Effective date. The provisions of this paragraph (b)(11) are 
applicable for taxable years beginning on or after July 23, 2002. For 
taxable years beginning before July 23, 2002, see Sec. 1.706-3T as 
contained in 26 CFR part 1 revised April 1, 2002.
* * * * *


Sec. 1.706-3T  [Removed]

    3. Section 1.706-3T is removed.

David A. Mader,
Deputy Commissioner of Internal Revenue.
    Approved: July 16, 2002.
Pamela F. Olson,
Acting Assistant Secretary of the Treasury.
[FR Doc. 02-18455 Filed 7-22-02; 8:45 am]
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