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Notice 2004-31
Part III - Administrative, Procedural, and Miscellaneous
Intercompany Financing Using Guaranteed Payments
Notice 2004-31
The Internal Revenue Service and Treasury Department are aware of a type of
transaction, described below, in which a corporation claims inappropriate deductions
for payments made through a partnership. This notice alerts taxpayers and their
representatives that these transactions are tax avoidance transactions and
identifies these transactions, and substantially similar transactions, as listed
transactions for purposes of § 1.6011-4(b)(2) of the Income Tax Regulations
and §§ 301.6111-2(b)(2) and 301.6112-1(b)(2) of the Procedure and
Administration Regulations. This notice also alerts parties involved with these
transactions of certain responsibilities that may arise from their involvement
with these transactions.
FACTS
The transactions described in this notice use a partnership in an attempt to
convert interest payments that would not be currently deductible under § 163(j)
into deductible payments. One such transaction involves the formation of
a partnership (PRS) by a domestic corporation (DC2) and a foreign person
(FP). FP is the common foreign parent, or an affiliate of the common foreign
parent, of the affiliated group (within the meaning of § 1504(a), but
without regard to § 1504(b)(3)) to which DC2 and a second domestic corporation
(DC1) belong. In the transaction, FP and DC2 contribute property to PRS.
PRS contributes a substantial portion of the contributed assets to DC1 in
exchange for preferred stock. Under the partnership agreement, FP is entitled
to (1) a substantial guaranteed payment for the use of capital, and (2) a
disproportionately small share (relative to FP's capital contribution) of
both the gross dividend income from DC1 and PRS’s deductions for guaranteed
payments. Under the partnership agreement, DC2 is entitled to a disproportionately
large share (relative to DC2’s capital contribution) of both the gross
dividend income from DC1 and PRS’s deductions for guaranteed payments.
Each year, DC1 pays substantial dividend income to PRS on the preferred stock.
PRS allocates to DC2 the dividend income as well as PRS’s deductions
for guaranteed payments. If the guaranteed payment right to FP were instead
debt of DC1 to FP, then interest on such indebtedness would be subject to the
limitations imposed by § 163(j). DC2 claims, based on its affiliation
with DC1 (the corporation paying the dividend), a 100 percent dividends received
deduction under § 243(a)(3) for its distributive share of dividend income.
In addition, DC2 deducts its distributive share of the guaranteed payment.
Consequently, DC2 claims a substantial net deduction.
In one variation of this transaction, PRS has an obligation to make guaranteed
payments to a partner (X) unrelated to FP and its affiliates and PRS’s
obligation to make guaranteed payments to X is assured by a related party,
such as FP, in a manner similar to a disqualified guarantee as defined in § 163(j)(6)(D),
so as to avoid treatment as disqualified interest under § 163(j)(3)(B).
DISCUSSION
The Service intends to challenge the purported tax benefits of these transactions
on various grounds. The Service may treat FP as directly acquiring an equity
investment in DC1, because FP and DC2 lack the requisite non-tax business
purpose to form a valid partnership. See ASA Investerings Partnership. v.
Commissioner, T.C. Memo 1998-305, aff’d, 201 F.3d 505 (D.C. Cir. 2000),
cert. denied, 531 U.S. 871 (2000); Andantech, L.L.C. v. Commissioner, T.C.
Memo 2002-97, aff’d, 331 F.3d 972 (D.C. Cir. 2003). The Service also
may challenge the transaction under the partnership anti-abuse rule contained
in § 1.701-2. In addition, the Service may challenge the purported tax
results on the grounds that the allocations under the partnership agreement
lack substantial economic effect (as discussed below) and are not in accordance
with the partners’ interests in the partnership as required by § 704(b).
In particular cases, the Service may argue that the allocations lack economic
effect. Alternatively, where the allocations have economic effect, or are deemed
to have economic effect, the Service may assert that such economic effect is
not substantial. The economic effect of allocations is not substantial if,
at the time the allocations became part of the partnership agreement, (i) the
after-tax economic consequences to one partner might, in present value terms,
have been enhanced compared to such consequences if the allocations had not
been contained in the partnership agreement, and (ii) there was a strong likelihood
that the after-tax economic consequences of no partner would, in present value
terms, have been substantially diminished compared to such consequences if
the allocations were not contained in the partnership agreement.
In the example described above, under the partnership agreement, DC2 is entitled
to a disproportionately large share of both the gross dividend income from
DC1 and PRS's deductions for guaranteed payments. To the extent the dividend
income and guaranteed payment deduction offset, this allocation will not alter
the economic returns of DC2 and FP compared to their returns if such items
were allocated to FP. Neither DC2 nor FP suffers a detriment to its after-tax
economic consequences as a result of the special allocations. However, the
allocations in the agreement will improve the after-tax consequences to DC2
because a larger share of partnership items will allow DC2 to claim a larger
net deduction attributable to the dividends received deduction. The Service
may argue, based on this analysis or on other relevant analyses, that the economic
effect of the allocations in the agreement is not substantial and that the
allocations are not in accordance with the partners’ interests in the
partnership.
Transactions that are the same as, or substantially similar to, the transactions
described in this notice are identified as "listed transactions" for
purposes of §§ 1.6011-4(b)(2), 301.6111-2(b)(2) and 301.6112-1(b)(2)
effective April 1, 2004, the date this notice was released to the public.
Independent of their classification as “listed transactions,” transactions
that are the same as, or substantially similar to, the transactions described
in this notice may already be subject to the disclosure requirements of § 6011
(§ 1.6011-4), the tax shelter registration requirements of § 6111
(§§ 301.6111-1T, 301.6111-2), or the list maintenance requirements
of § 6112 (§ 301.6112-1). Persons who are required to register these
tax shelters under § 6111 but have failed to do so may be subject to the
penalty under § 6707(a). Persons who are required to maintain lists of
investors under § 6112 but have failed to do so (or who fail to provide
those lists when requested by the Service) may be subject to the penalty under § 6708(a).
In addition, the Service may impose penalties on parties involved in these
transactions or substantially similar transactions, including the accuracy-related
penalty under § 6662.
The principal authors of this notice are David J. Sotos of the Office of Associate
Chief Counsel (International) and Sean Kahng of the Office of Associate Chief
Counsel (Passthroughs and Special Industries). For further information regarding
this notice contact Mr. Sotos at (202) 622-3860 or Mr. Kahng at (202) 622-3050
(not a toll-free call).