Taxable Years of Partner & Partnership;
Foreign Partners

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-104876-00] RIN 1545-AY66

TITLE: Taxable Years of Partner and Partnership; Foreign Partners

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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
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, §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., §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 §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 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 §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 §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 §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 §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, §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.

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:

§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 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 §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

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