[Federal Register Volume 73, Number 97 (Monday, May 19, 2008)]
[Rules and Regulations]
[Pages 28699-28704]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-11176]



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  Federal Register / Vol. 73, No. 97 / Monday, May 19, 2008 / Rules and 
Regulations  

[[Page 28699]]



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9398]
RIN 1545-BD70


Partner's Distributive Share

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations providing rules for 
testing whether the economic effect of an allocation is substantial 
within the meaning of section 704(b) where partners are look-through 
entities or members of a consolidated group. The final regulations 
clarify the application of section 704(b) to partnerships the interests 
of which are owned by look-through entities and members of consolidated 
groups and, through an example, reiterate the effect of other 
provisions of the Internal Revenue Code (Code) on partnership 
allocations. The final regulations affect partnerships and their 
partners.

DATES: Effective Date: The final regulations are effective on May 19, 
2008.
    Applicability Date: The final regulations apply to partnership 
taxable years beginning on or after May 19, 2008.

FOR FURTHER INFORMATION CONTACT: Jonathan E. Cornwell and Kevin I. 
Babitz at (202) 622-3050 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR part 1 under section 
704 of the Internal Revenue Code (Code). On November 18, 2005, proposed 
regulations (REG-144620-04) regarding the substantiality of allocations 
to partners that are look-through entities or members of a consolidated 
group were published in the Federal Register (70 FR 69919). Because no 
requests to speak were submitted by January 25, 2006, no public hearing 
was held (see 71 FR 7453). The IRS did receive a number of written 
comments responding to the proposed regulations, and, after 
consideration of the comments, the proposed regulations are adopted as 
revised by this Treasury decision.
    Section 704(a) provides that a partner's distributive share of 
partnership income, gain, loss, deduction, or credit shall, except as 
otherwise provided, be determined by the partnership agreement. Section 
704(b) provides that a partner's distributive share of income, gain, 
loss, deduction, or credit (or item thereof) shall be determined in 
accordance with the partner's interest in the partnership (determined 
by taking into account all facts and circumstances) if the allocation 
to the partner under the partnership agreement of income, gain, loss, 
deduction, or credit (or item thereof) does not have substantial 
economic effect.
    In order for an allocation to have substantial economic effect, it 
must have economic effect and such economic effect must be substantial. 
For an allocation to have economic effect, it must be consistent with 
the underlying economic arrangement of the partners. This means that, 
in the event there is an economic benefit or burden that corresponds to 
the allocation, the partner to whom the allocation is made must receive 
the economic benefit or bear such economic burden. See Sec.  1.704-
1(b)(2)(ii).
    Allocations to a partner will have economic effect if, and only if, 
throughout the full term of the partnership, the partnership agreement 
provides for: (i) The proper maintenance of the partners' capital 
accounts, (ii) upon liquidation of the partnership (or any partner's 
interest in the partnership) liquidating distributions are required to 
be made in accordance with the positive capital account balances of the 
partners, as determined after taking into account all necessary 
adjustments for the partnership's taxable year during which the 
liquidation occurs, by the end of such taxable year, or if later, 90 
days after the date of such liquidation, and (iii) if such partner has 
a deficit balance in the partner's capital account following the 
liquidation of the interest after taking into account all necessary 
adjustments for the partnership taxable year during which the 
liquidation occurs, the partner is unconditionally obligated to restore 
the deficit balance by the end of such taxable year (or, if later, 
within 90 days after the date of the liquidation), which amount is paid 
to the partnership's creditors or distributed to the other partners in 
accordance with their positive capital account balances. See Sec.  
1.704-1(b)(2)(ii)(b).
    Even if the partnership agreement does not require an unlimited 
deficit restoration obligation of a partner, the allocation may still 
have economic effect to the extent such allocation does not cause or 
increase a deficit balance in the partner's capital account (in excess 
of any limited dollar amount of such partner's deficit restoration 
obligation) if requirements (1) and (2) of Sec.  1.704-1(b)(2)(ii)(b) 
are satisfied and the partnership agreement contains a ``qualified 
income offset.'' Section 1.704-1(b)(2)(ii)(d). Finally, allocations 
that do not otherwise have economic effect under the foregoing rules 
shall be deemed to have economic effect if at the end of each 
partnership taxable year a liquidation of the partnership at the end of 
such year or at the end of any future year would produce the same 
economic results to the partners if such rules had been satisfied 
regardless of the economic performance of the partnership. Section 
1.704-1(b)(2)(ii)(i).
    As a general rule, the economic effect of an allocation (or 
allocations) is substantial if there is a reasonable possibility that 
the allocation (or allocations) will affect substantially the dollar 
amounts to be received by the partners from the partnership, 
independent of tax consequences. See Sec.  1.704-1(b)(2)(iii). Even if 
the allocation affects substantially the dollar amounts to be received 
by the partners from the partnership, the economic effect of the 
allocation (or allocations) is not substantial if, at the time the 
allocation (or allocations) becomes part of the partnership agreement, 
(1) the after-tax economic consequences of at least one partner may, in 
present value terms, be enhanced compared to such consequences if the 
allocation (or allocations) were not contained in the partnership 
agreement, and (2) there is

[[Page 28700]]

a strong likelihood that the after-tax economic consequences of no 
partner will, in present value terms, be substantially diminished 
compared to such consequences if the allocation (or allocations) were 
not contained in the partnership agreement. See Sec.  1.704-
1(b)(2)(iii).
    This test is commonly referred to as the after-tax test. In 
determining the after-tax economic benefit or detriment of an 
allocation to a partner, the tax consequences that result from the 
interaction of the allocation with such partner's tax attributes that 
are unrelated to the partnership will be taken into account. Finally, 
the economic effect of an allocation is not substantial in two 
situations described in Sec.  1.704-1(b)(2)(iii)(b) and (b)(2)(iii)(c). 
The latter two situations are generally described as ``shifting'' and 
``transitory'' allocations, respectively.
    If the partnership agreement provides for an allocation of income, 
gain, loss, deduction, or credit (or item thereof) to a partner that 
does not have substantial economic effect, then the partner's 
distributive share of the income, gain, loss, deduction, or credit (or 
item thereof) is determined in accordance with the partner's interest 
in the partnership. References in section 704(b) or Sec.  1.704-1 to a 
partner's interest in the partnership, or to the partners' interests in 
the partnership, signify the manner in which the partners have agreed 
to share the economic benefit or burden (if any) corresponding to the 
income, gain, loss, deduction, or credit (or item thereof) that is 
allocated, taking into account all facts and circumstances relating to 
the economic arrangement of the partners. See Sec.  1.704-1(b)(3).
    Section 1.704-1(b)(1)(iii) provides that an allocation that is 
respected under section 704(b) nevertheless may be reallocated under 
other provisions, such as section 482, section 704(e)(2), section 
706(d) (and related assignment of income principles), and Sec.  1.751-
1(b)(2)(ii).
    The proposed regulations clarify several aspects of the regulations 
under section 704. The proposed regulations generally provide a ``look-
through rule'' for purposes of testing the substantiality of an 
allocation. The proposed regulations provide that in determining the 
after-tax economic benefit or detriment of a partnership allocation to 
any partner that is a look-through entity, the look-through rule takes 
into account the tax consequences that result from the interaction of 
the allocation with the tax attributes of any owner of the look-through 
entity. Similarly, in determining the after-tax economic benefit or 
detriment to any partner that is a member of a consolidated group, the 
proposed regulations generally provide that the tax consequences that 
result from the interaction of the allocation with the tax attributes 
of the consolidated group and with the tax attributes of another member 
with respect to a separate return year must be taken into account. The 
proposed regulations provide that a look-through entity means a 
partnership, subchapter S corporation, trust, an entity disregarded for 
Federal tax purposes, or certain controlled foreign corporations 
(CFCs).
    The proposed regulations clarify that, for purposes of Sec.  1.704-
1(b)(2)(iii)(a), the after-tax economic consequences of an allocation 
contained in the partnership agreement was compared to the after-tax 
economic consequences of the allocation made in accordance with the 
partners' interest in the partnership (within the meaning of Sec.  
1.704-1(b)(3)). For that purpose, the partners' interest in the 
partnership was determined as if the allocations tested were not 
contained in the partnership agreement. Also, the proposed regulations 
remove the per capita presumption in Sec.  1.704-1(b)(3)(i). Finally, 
the proposed regulations include an example illustrating one 
circumstance where a provision other than section 704(b) may be used to 
reallocate partnership items.

Summary of Comments and Explanation of Provisions

    The final regulations adopt the proposed regulations with 
clarification of certain aspects in response to the comments received.

A. Look-Through Entities and Members of a Consolidated Group

    For purposes of applying the after-tax, shifting, and transitory 
tests to a partner that is a look-through entity, the final regulations 
provide that the tax consequences that result from the interaction of 
an allocation with the tax attributes of any person that is an owner, 
or in the case of a trust or estate, the beneficiary, of an interest in 
such partner must be taken into account.
    The final regulations define a look-through entity as a 
partnership, subchapter S corporation, trust, estate, an entity 
disregarded for Federal tax purposes, or certain controlled foreign 
corporations (CFCs). The final regulations change the look-through rule 
for CFCs (CFC look-through rule) to provide an ownership threshold that 
must be met in order to trigger look-through treatment. One comment 
suggested that, for administrative reasons, the look-through rule 
should apply only in cases involving partnerships (whether U.S. or 
foreign) that meet the control test in section 6038. The IRS and the 
Treasury Department agree that administrative concerns justify limiting 
the CFC look-through rule but are concerned that limiting the 
application of the rule as suggested would provide opportunities for 
abuse. Accordingly, the final regulations limit application of the CFC 
look-through rule to cases in which United States shareholders (within 
the meaning of section 951(b)) of the CFC in the aggregate own, 
directly or indirectly, at least 10 percent of the capital or profits 
interests of the partnership.
    In addition, the final regulations clarify that a CFC is treated as 
a look-through entity, but only with respect to allocations of items of 
income, gain, loss, or deduction that enter into the computation of a 
United States shareholder's inclusion under section 951(a) with respect 
to the controlled foreign corporation, enter into any person's income 
attributable to a United States shareholder's inclusion under section 
951(a) with respect to the controlled foreign corporation, or would 
enter into the computations described in this paragraph if such items 
were allocated to the controlled foreign corporation. The Treasury 
Department and the IRS are further considering whether a CFC partner 
should be treated as a look-through entity in all cases and how any 
impact on the tax liability of a direct or indirect owner of the CFC 
partner resulting from actual or anticipated distributions of property 
by the CFC partner under section 301 should be taken into account in 
testing the substantiality of an allocation.
    Comments were also received on other aspects of the look-through 
rule. One comment suggested that the definition of look-through entity 
be expanded to include estates. Because estates generally pass through 
attributes in the same manner as trusts, this comment is adopted. 
Another comment questioned the inclusion of disregarded entities in the 
list of look-through entities. The proposed regulations included 
disregarded entities because such entities are the actual state law 
partners in the partnership. The final regulations include disregarded 
entities in the list of look-through entities for this reason only.
    Several comments requested modifications to the look-through rule 
based upon their contention that the rule was burdensome. One comment 
suggested the abandonment of the look-through rule entirely, believing 
the application of Sec.  1.701-2 would protect

[[Page 28701]]

the concerns underlying the proposed regulations and would be less 
burdensome. Another comment suggested that a five year presumption be 
included with respect to the after-tax test in Sec.  1.704-
1(b)(2)(iii)(a), such that the economic effect of any allocation 
occurring five years after the date upon which the allocation became a 
part of the partnership agreement would be presumed to be substantial. 
Finally, several comments requested either that the look-through rule 
apply only to partners owning more than 20 percent of the profits or 
capital of the partnership or that the look-through rule provide 
procedures to help partnerships ease the burden of considering the tax 
attributes of their partners and indirect owners.
    One proposal to simplify the application of the look-through rule 
was to include a presumption that the partnership did not know and 
would not be required to investigate the tax attributes of any partner 
unless that partner directly or indirectly owns more than a 25 percent 
interest in the partnership's capital or profits. Alternatively, it was 
suggested that the final regulations provide certification procedures 
pursuant to which a partnership would be entitled to rely on a 
statement from its direct or indirect owner regarding such person's tax 
attributes.
    The substantiality test in its present form was adopted in 1986. 
The Treasury Department and the IRS believe that the final regulations 
merely confirm the proper application of the substantiality test in 
those instances in which the partnership is owned by one or more look-
through entities. In that respect, the look-through rule in the final 
regulations is not a change to the substantiality test. The Treasury 
Department and the IRS do not believe that it is necessary at this time 
to simplify the application of the substantiality test as suggested by 
the comments. However, to address the concerns expressed regarding the 
burden of the substantiality test as it applies to partnerships with 
look-through entity partners, the final regulations include a de 
minimis rule that provides that, for purposes of determining 
substantiality, the tax attributes of de minimis partners need not be 
taken into account. A de minimis partner is any partner, including a 
look-through entity, that owns less than 10 percent of the capital and 
profits of a partnership, and who is allocated less than 10 percent of 
each partnership item. Because of the inclusion of this de minimis 
rule, the final regulations do not provide for a certification 
procedure.
    Some comments requested that the final regulations clarify what 
constitutes a ``tax attribute'' and an ``interaction.'' The IRS and the 
Treasury Department believe that this issue is sufficiently addressed 
under the current regulations, and, therefore, no further guidance is 
provided in the final regulations.
    Finally, one comment requested that the final regulations provide 
guidance for situations in which the interaction of an allocation to a 
look-through entity, such as a trust or estate, and the tax attributes 
of the beneficiary of the entity are dependent on other factors such as 
the timing and amount of distributions from the trust or estate to the 
beneficiary. For example, it may be difficult to evaluate an allocation 
to a partner that is a trust where it is not known what distributions 
the trust will make. The IRS and the Treasury Department believe that 
this issue is addressed by the ``strong likelihood'' language of the 
substantiality test and, therefore, the final regulations do not 
provide additional guidance.

B. The Baseline for Comparison in Sec.  1.704-1(b)(2)(iii)

    Section 1.704-1(b)(2)(iii)(a) provides that the economic effect of 
an allocation is not substantial if, at the time the allocation becomes 
part of the partnership agreement, the after-tax economic consequences 
of at least one partner may, in present value terms, be enhanced 
compared to such consequences if the allocation were not contained in 
the partnership agreement, and there is a strong likelihood that the 
after-tax economic consequences of no partner will, in present value 
terms, be substantially diminished compared to such consequences if the 
allocation were not contained in the partnership agreement. Because 
taxpayers have suggested that the baseline comparison required by this 
provision is unclear, the proposed regulations clarified this rule, 
consistent with the provisions of Sec.  1.704-1(b)(1)(i), by explaining 
that the after-tax economic consequences that result from the 
allocation must be compared to such consequences that would result if 
the allocations were not contained in the partnership agreement and 
were determined in accordance with the partners' interests in the 
partnership.
    One comment suggested that an inconsistency existed between 
identifying the partners' interests in the partnership as the baseline 
for comparison in Sec.  1.704-1(b)(2)(iii)(a)(1) and (2) and the 
conclusions reached by Sec.  1.704-1(b)(5) Example 5. According to this 
comment, paragraph (ii) of Sec.  1.704-1(b)(5) Example 5 provides that 
the sharing percentages under the partners' interests in the 
partnership standard was 36 percent for one partner and 64 percent for 
the other partner. Comparing the after-tax economic consequences of the 
allocations contained in the partnership agreement with the 36/64 
sharing percentages results in the after-tax economic consequences of 
one partner being enhanced and those of the other partner being 
substantially diminished. Thus, according to the comment, the 
conclusion in paragraph (i) of Sec.  1.704-1(b)(5) Example 5 cannot be 
correct. The after-tax test, however, is applied by comparing the 
allocations contained in the partnership agreement with the 
consequences determined in accordance with the partners' interests in 
the partnership had the allocations not been part of the partnership 
agreement. In Example 5, aside from the allocations being tested, the 
partners shared all other items equally and made equal capital 
contributions. To apply the substantiality test to the special 
allocations in that example, the results were compared to what would 
have occurred if the partners had 50/50 sharing percentages. This 
comparison revealed that one partner's after-tax economic return was 
enhanced and no partner's after-tax return was substantially 
diminished. Thus, the specially allocated items had to be reallocated 
under the partners' interests in the partnership. Under the facts of 
Example 5, the partners' interests in the partnership were the 36/64 
sharing percentages, which were the same percentages in which they 
actually shared the partnership's total income for the year. The 
reallocation did not change the percentages in which the partners 
shared total income, but rather, required that each item of income 
(that is, tax-exempt income and taxable interest and dividends included 
in total income) be shared in those same percentages. Thus, in Example 
5 the partners' interests in the partnership for purposes of 
reallocating the items that lacked substantial economic effect was 
determined to be different than the partners' interests in the 
partnership used to test substantiality.
    One comment suggested that the comparison to the partners' 
interests in the partnership is equally applicable when testing 
shifting and transitory allocations under Sec.  1.704-1(b)(2)(iii)(b) 
and (c) as it is to the after-tax test under Sec.  1.704-
1(b)(2)(iii)(a), and suggested that the final regulations so provide. 
This comment is adopted and, in order to further clarify that the 
partners'

[[Page 28702]]

interests in the partnership (determined without regard to the 
allocation or allocations being tested) is the baseline for comparison 
when testing the substantiality of an allocation, whether under the 
after-tax test or the shifting or transitory allocation test, the final 
regulations remove the parenthetical clauses inserted by the proposed 
regulations and add a sentence to the end of Sec.  1.704-
1(b)(2)(iii)(a)(1) that provides that references in Sec.  1.704-
1(b)(2)(iii) to an allocation (or allocations) not contained in the 
partnership agreement mean that the allocation (or allocations) is 
determined in accordance with the partners' interests in the 
partnership (within the meaning of paragraph Sec.  1.704-1(b)(3)), 
disregarding the allocation (or allocations) being tested under Sec.  
1.704-1(b)(2)(iii).

C. Removal of Per Capita Presumption in Sec.  1.704-1(b)(3)

    The proposed regulations removed the per capita presumption in 
Sec.  1.704-1(b)(3). Because this section generally does not contain 
mechanical rules to determine the partners' interests in the 
partnership, one comment suggested that the presumption was necessary 
to reduce complexity, and therefore recommended that the final 
regulations reinsert the presumption. However, because the per capita 
presumption failed to consider factors relevant to a determination of 
the manner in which the partners agreed to share the economic benefits 
or burdens corresponding to the allocation of partnership items, the 
correct result was reached in very few cases. Accordingly, the Treasury 
Department and IRS believe that any benefits of the presumption are 
outweighed by the potential for incorrect determinations.

D. Example 29

    In Example 29 of the proposed regulations, B, a domestic 
corporation, and C, a controlled foreign corporation, form BC, a 
partnership organized under the laws of a foreign jurisdiction, with 
equal capital contributions. B and C are both wholly owned by A, a 
domestic corporation. Substantially all of BC's income would not be 
subpart F income if earned directly by C. For the first fifteen years 
of the partnership, gross income is allocated 10 percent to B and 90 
percent to C, and all deductions and losses will be allocated 90 
percent to B and 10 percent to C. After the initial fifteen year 
period, BC's gross income will be allocated 90 percent to B and 10 
percent to C, and all deductions and losses will be allocated 10 
percent to B and 90 percent to C. The example concludes that, apart 
from the application of section 704(b), the Commissioner may reallocate 
or otherwise not respect the allocations under other Code sections.
    One comment questioned why Example 29 did not contain a substantial 
economic effect analysis. Another comment inferred from the absence of 
a citation to Sec.  1.701-2 in Example 29 that the partnership anti-
abuse rule did not apply and would not be asserted by the IRS. Example 
29 was included in the proposed regulations only to reiterate the 
provisions contained in Sec.  1.704-1(b)(1)(iii) regarding the effect 
other sections may have on partnership allocations. Accordingly, the 
Treasury Department and IRS do not believe that any further analysis is 
necessary. Moreover the list of other sections that can affect the 
validity of a partnership allocation in Sec.  1.704-1(b)(1)(iii) is not 
an exhaustive list and, accordingly, the absence of a citation to Sec.  
1.701-2 or other potentially applicable sections does not preclude the 
applicability of those provisions of law in the appropriate 
circumstances. The Treasury Department and IRS continue to consider 
issuing additional guidance addressing the proper treatment of special 
allocations of items of a partnership that is owned primarily by 
related parties. Examples 29 and 30 in the proposed regulations have 
been renumbered as Examples 28 and 29, respectively, in these final 
regulations.

Effective/Applicability Date

    The amendments made by these final regulations apply to partnership 
taxable years beginning on or after May 19, 2008.

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) 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 Code, the notice of 
rulemaking preceding these regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Drafting Information

    The principal authors of this regulation are Jonathan E. Cornwell 
and Kevin I. Babitz, Office of the Associate Chief Counsel 
(Passthroughs & Special Industries). However, other personnel from the 
IRS and Treasury Department participated in its development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows: Authority: 26 U.S.C. 7805. * * *

0
Par. 2. Section 1.704-1 is amended as follows:

0
1. A sentence is added at the end of paragraph (b)(1)(ii)(a).
0
2. A sentence is added at the end of paragraph (b)(2)(iii)(a).
0
3. Paragraphs (b)(2)(iii)(d) and (e) are added.
0
4. The last two sentences of paragraph (b)(3)(i) are removed.
0
5. Paragraph (b)(5) Examples 28, 29 and 30 are added.
    The additions and revisions read as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) * * *
    (1) * * *
    (ii) Effective/applicability dates. (a) * * * Paragraphs 
(b)(2)(iii)(a) (last sentence), (b)(2)(iii)(d), (b)(2)(iii)(e), and 
(b)(5) Example 28, Example 29, and Example 30 of this section apply to 
partnership taxable years beginning on or after May 19, 2008.
    (2) * * *
    (iii) * * * (a) * * * References in this paragraph (b)(2)(iii) to a 
comparison to consequences arising if an allocation (or allocations) 
were not contained in the partnership agreement mean that the 
allocation (or allocations) is determined in accordance with the 
partners' interests in the partnership (within the meaning of paragraph 
(b)(3) of this section), disregarding the allocation (or allocations) 
being tested under this paragraph (b)(2)(iii).
* * * * *
    (d) Partners that are look-through entities or members of a 
consolidated group-- (1) In general. For purposes of applying 
paragraphs (b)(2)(iii)(a), (b),

[[Page 28703]]

and (c) of this section to a partner that is a look-through entity, the 
tax consequences that result from the interaction of the allocation 
with the tax attributes of any person that is an owner, or in the case 
of a trust or estate, the beneficiary, of an interest in such a 
partner, whether directly or indirectly through one or more look-
through entities, must be taken into account. For purposes of applying 
paragraphs (b)(2)(iii)(a), (b), and (c) of this section to a partner 
that is a member of a consolidated group (within the meaning of Sec.  
1.1502-1(h)), the tax consequences that result from the interaction of 
the allocation with the tax attributes of the consolidated group and 
with the tax attributes of another member with respect to a separate 
return year must be taken into account. See paragraph (b)(5) Example 29 
of this section.
    (2) Look-through entity. For purposes of this paragraph 
(b)(2)(iii)(d), a look-through entity means--
    (i) A partnership;
    (ii) A subchapter S corporation;
    (iii) A trust or an estate;
    (iv) An entity that is disregarded for Federal tax purposes, such 
as a qualified subchapter S subsidiary under section 1361(b)(3), an 
entity that is disregarded as an entity separate from its owner under 
Sec. Sec.  301.7701-1 through 301.7701-3 of this chapter, or a 
qualified REIT subsidiary within the meaning of section 856(i)(2); or
    (v) A controlled foreign corporation if United States shareholders 
of the controlled foreign corporation in the aggregate own, directly or 
indirectly, at least 10 percent of the capital or profits of the 
partnership on any day during the partnership's taxable year. In such 
case, the controlled foreign corporation shall be treated as a look-
through entity, but only with respect to allocations of income, gain, 
loss, or deduction (or items thereof) that enter into the computation 
of a United States shareholder's inclusion under section 951(a) with 
respect to the controlled foreign corporation, enter into any person's 
income attributable to a United States shareholder's inclusion under 
section 951(a) with respect to the controlled foreign corporation, or 
would enter into the computations described in this paragraph if such 
items were allocated to the controlled foreign corporation. See 
paragraph (b)(2)(iii)(d)(6) for the definition of indirect ownership.
    (3) Controlled foreign corporations. For purposes of this section, 
the term controlled foreign corporation means a controlled foreign 
corporation as defined in section 957(a) or section 953(c). In the case 
of a controlled foreign corporation that is a look-through entity, the 
tax attributes to be taken into account are those of any person that is 
a United States shareholder (as defined in paragraph (b)(2)(iii)(d)(5) 
of this section) of the controlled foreign corporation, or, if the 
United States shareholder is a look-through entity, a United States 
person that owns an interest in such shareholder directly or indirectly 
through one or more look-through entities.
    (4) United States person. For purposes of this section, a United 
States person is a person described in section 7701(a)(30).
    (5) United States shareholder. For purposes of this section, a 
United States shareholder is a person described in section 951(b) or 
section 953(c).
    (6) Indirect ownership. For purposes of this section, indirect 
ownership of stock or another equity interest (such as an interest in a 
partnership) shall be determined in accordance with the principles of 
section 318, substituting the phrase ``10 percent'' for the phrase ``50 
percent'' each time it appears.
    (e) De minimis rule. For purposes of applying this paragraph 
(b)(2)(iii), the tax attributes of de minimis partners need not be 
taken into account. For purposes of this paragraph (b)(2)(iii)(e), a de 
minimis partner is any partner, including a look-through entity that 
owns, directly or indirectly, less than 10 percent of the capital and 
profits of a partnership, and who is allocated less than 10 percent of 
each partnership item of income, gain, loss, deduction, and credit. See 
paragraph (b)(2)(iii)(d)(6) of this section for the definition of 
indirect ownership.
* * * * *
    (5) * * *

    Example 28. (i) B, a domestic corporation, and C, a controlled 
foreign corporation, form BC, a partnership organized under the laws 
of country X. B and C each contribute 50 percent of the capital of 
BC. B and C are wholly-owned subsidiaries of A, a domestic 
corporation. Substantially all of BC's income would not be subpart F 
income if earned directly by C. The BC partnership agreement 
provides that, for the first fifteen years, BC's gross income will 
be allocated 10 percent to B and 90 percent to C, and BC's 
deductions and losses will be allocated 90 percent to B and 10 
percent to C. The partnership agreement also provides that, after 
the initial fifteen year period, BC's gross income will be allocated 
90 percent to B and 10 percent to C, and BC's deductions and losses 
will be allocated 10 percent to B and 90 percent to C.
    (ii) Apart from the application of section 704(b), the 
Commissioner may reallocate or otherwise not respect the allocations 
under other sections. See paragraph (b)(1)(iii) of this section. For 
example, BC's allocations of gross income, deductions, and losses 
may be evaluated and reallocated (or not respected), as appropriate, 
if it is determined that the allocations result in the evasion of 
tax or do not clearly reflect income under section 482.
    Example 29. PRS is a partnership with three equal partners, A, 
B, and C. A is a corporation that is a member of a consolidated 
group within the meaning of Sec.  1.1502-1(h). B is a subchapter S 
corporation that is wholly owned by D, an individual. C is a 
partnership with two partners, E, an individual, and F, a 
corporation that is member of a consolidated group within the 
meaning of Sec.  1.1502-1(h). For purposes of paragraph (b)(2)(iii) 
of this section, in determining the after-tax economic benefit or 
detriment of an allocation to A, the tax consequences that result 
from the interaction of the allocation to A with the tax attributes 
of the consolidated group of which A is a member must be taken into 
account. In determining the after-tax economic benefit or detriment 
of an allocation to B, the tax consequences that result from the 
interaction of the allocation with the tax attributes of D must be 
taken into account. In determining the after-tax economic benefit or 
detriment of an allocation to C, the tax consequences that result 
from the interaction of the allocation with the tax attributes of E 
and the consolidated group of which F is a member must be taken into 
account.
     Example 30. (i) A, a controlled foreign corporation, and B, a 
foreign corporation that is not a controlled foreign corporation, 
form AB, a partnership organized under the laws of country X. The 
partnership agreement contains the provisions necessary to comply 
with the economic effect safe harbor of paragraph (b)(2)(ii)(b) of 
this section. A is wholly-owned by C, a domestic corporation that is 
not a member of a consolidated group within the meaning of Sec.  
1.1502-1(h). B is wholly owned by an individual who is a citizen and 
resident of country X and is not related to A. Neither A, B, nor AB, 
is engaged in a trade or business in the United States. A and B each 
contribute 50 percent of the capital of AB. There is a strong 
likelihood that in each of the next several years AB will realize 
equal amounts of gross income that would constitute subpart F income 
if allocated to A, and gross income that would not constitute 
subpart F income if allocated to A (``non-subpart F income''). A and 
B agree to share bottom-line net income from AB equally; however, 
rather than share all items of gross income equally, A and B agree 
that B will be allocated all of AB's subpart F income to the extent 
of its 50 percent share of bottom-line net income. In year 1, AB 
earns $60x of income, $30x of which is subpart F income and is 
allocated to B, and $30x of which is non-subpart F income and is 
allocated to A.
    (ii) Although neither A nor B is subject to U.S. tax with 
respect to its distributive share of the income of AB, under 
paragraph (b)(2)(iii)(d) of this section, the tax attributes of C 
must be taken into account with respect to A for purposes of 
applying the tests described in paragraphs (b)(2)(iii)(a), (b), and 
(c) of this section. The allocations in year 1

[[Page 28704]]

have economic effect. However, the economic effect of the 
allocations is not substantial under the test described in paragraph 
(b)(2)(iii)(b) of this section because there was a strong 
likelihood, at the time the allocations became part of the AB 
partnership agreement, that the net increases and decreases to A's 
and B's capital accounts in year 1 would not differ substantially 
when compared to the net increases and decreases to A's and B's 
capital accounts for year 1 if the allocations were not contained in 
the partnership agreement, and the total tax liability from the 
income earned by AB in year 1 (taking into account the tax 
attributes of the allocations to C) would be reduced as a result of 
such allocations. Under paragraph (b)(3) of this section, the 
subpart F income and non-subpart F income earned by AB in year 1 
must each be reallocated 50 percent to A and 50 percent to B.
* * * * *

    Approved: May 8, 2008.
Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E8-11176 Filed 5-16-08; 8:45 am]
BILLING CODE 4830-01-P