Abusive Partnership Intercompany Financings
IRS Notice 2004-31

 

In IRS Notice 2004-31, the government announced that they had become aware of an abusive transaction in which a corporation claims inappropriate deductions for payments run through a partnership, in which it appears that use of a partnership is part of an attempt to convert interest payments not deductible under 163(j) into deductible payments.

The IRS intends on challenging the purported tax benefits of these transactions on various grounds. First, the IRS 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 (citing to ASA Investerings and Andantech). The IRS also may challenge the transaction using the partnership anti-abuse rule contained in Regs. Section 1.701-2. The IRS also may challenge the purported tax results on the grounds that the allocations under the partnership agreement lack substantial economic effect (and are not in accordance with the partners’ interests in the partnership as required under Section 704(b)).

In particular, the IRS points out how under the partnership agreement, DC2 is entitled to a disproportionately large share of both the gross dividend income from DC1 and the partnership’s deductions for guaranteed payments. To the extent that the dividend income and guaranteed payment deduction offset, this allocation will not alter the economic returns of DC2 and FP. Neither DC2 nor FP suffers a detriment to its after-tax economic consequences as a result of 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. For these reasons, the IRS may argue that the economic effect of the allocations in the agreement is not substantial.

If you believe that you may have engaged in a transaction that is the same or substantially similar to the transaction described above, Federal law may require you to disclose your and other parties’ participation in any such “listed transaction” on IRS Form 8886. For more information about Federal law requirements, please contact us.