Tuesday, November 21, 2017
What are the implications for partnerships and partnership taxation under the Republican proposals for tax reform?
Charles Lincoln, Esq. (LL.M. International Tax) authors this article analyzing from an international tax law perspective, what might be the effects of the new proposed partnership rules in the US? Charles Lincoln may be contacted at [email protected]
Partnerships are a complex combination of sole proprietorship rules, corporate rules, and financial accounting rules—the tax consequences are outlined primarily in Subchapter K of the US Internal Revenue Code. Partnerships often involve individuals and individuals with corporations acting as partners engaging in business. However, when comparing the US approach to partnerships, there can be differences—especially in the concept of opaque and flow entity through taxation. Opaque is when the profits are taxed at the corporate entity level and flow through is when the profits are taxed at the individual level.
In the United States, there is an option to “check the box” whereby one can qualify for flow through status—and this has been a rule since the 1990s. In other countries, there can be different approaches and modes of analysis to determine whether an entity is flow through or opaque. It is important to consider how the US system as it stands currently relates to other countries—and how the proposed changes could alter these inter-national relations.
Partnership Loans in Action:
Practically speaking, there can be vast differences of tax consequences between the opaque approach and the flow through approach. When dealing with a loan from a partner to the partnership in the flow through approach, the loan is really a loan to the partner—thus the tax administrations disregard it at the partner level. Interest paid on that loan is really a distribution of the partnership income to the partner. This can lead to some sincerely tricky situations of whether the loan is an equity injection or not and whether the “interest” paid is really a dividend received. The divergence is hard to tell sometimes.
On the other hand, when dealing with the flow through approach, the partner giving a loan to the partnership could be treated as a loan from a third party to the partnership. In that case, the interest is income to the partner, the interest deduction is given to the partnership [i.e. passed through the appropriate partner(s)], and the question remains as with the opaque approach whether this is really “interest.”
One behavioral consideration in this relatively concrete example of the loan from a partner to the partnership is what the consequences are if the corporate income tax rates fall and what happens with large partnerships—such as accounting firms or law firms. If there are lower corporate income tax rates, then how are the dividends treated, and how are the profits reinvested.
Practical and Policy Considerations:
When tax rates—such as the cascading tax rates proposed in both the House and Senate tax proposals—come into existence, a prudent partnership would have to reorganize itself. In such a reorganization, the partnership would have to decide whether the loan is treated as a distribution of dividends or interest—in the opaque scenario—and whether the loan is treated as income straight to the partner or whether the interest may be deducted when paid from the partnership to the partner—in the flow through example.
As a matter of policy, changes in the corporate income tax, could lead to changes in the personal income tax—assuming a lobbying effort goes into place to follow through with lowering the individual rates. This is because if corporate taxes are changed, then the partner may not want to take out money from the partnership—because her income bracket could be at a higher rate than the corporate rate. Thus, there is an ebb and flow with these scenarios.
The Tax Reform Proposals Affecting Partnerships:
In the Senate Chairman’s Markup of the Tax Cut and Job Act proposal, there are rules regarding hybrid entities that would eliminate deductions for certain non-qualified party related amounts paid or accrued to hybrid entitles or in hybrid transactions. This is probably similar to the OECD suggestions in BEPS Action 2. This is likely going to be a problem for foreign companies financing into the United States. The House Ways & Means Proposal has not spoken on this yet.
Per interest expense limitations, the House has suggested that 30% of adjusted taxable income—in other words the EBITA (earnings before interest, taxes, and amortization) or regarding worldwide groups 110% of the allocation of net thread party interest expenses to the US corruption allocated on EBITA would be allowed for interest expense limitations.
Regarding interest expense limitations, the Senate suggested that the lesser of either 30% of the adjusted taxable income or the limitation based on the amount of debt that the US would hold if the US debt-to equity ratio were propionate to worldwide debt-to-equity ratio limitations. This seems to have roots in BEPS Action 4—especially for the debt-to-equity ratio limitation proposals.
Finally, considering controlled foreign corporation rules, most existing CFC rules in Subpart F of the IRC will be maintained with both the House and Senate proposals. However, there is another added layer of complexity.
The House suggests that a new CFC rule should allow for 50% of the aggregate profits of all CFCs, above a routine return on tangible assets, subject to a taxable income inclusion. It also includes a foreign tax credit allowed for 80% of foreign taxes actually paid by CFCs. The result of this is that US residual tax would lead to an effective tax rate on foreign earnings of CFCS would be too low.
This “residual” tax would lead to some more complexity. If you have a double Irish sandwich at a low tax rate—such as 5.5%--you may have to pay a residual tax. The question is how sustainable this new system would be given its complexity, especially when adding another complexity considering what would tax consequences would occur when you bring IP home under IRC §367. Jokingly such a level of complexity, could ultimately lead one to favor formulary apportionment.
On the Senate side of the CFC proposal, the Senate suggest that 100% of the aggregate profits of all CFCs, above a routine return on tangible assets, would be subject to a taxable income inclusion and foreign tax credits would be allowed for 80% of foreign taxes “actually” paid by the CFC. There is also a provision for a special income tax rate of 10% applied to the taxable income inclusion.
How is this Going to Affect Business?
The rates themselves are highly variable and subject to change. But, there likely will be tax rate changes—at a minimum if the tax reform goes through. When these changes occur, the most immediate change will likely be a restructuring of partnerships determining whether income should be allocated to the partners or remain in the partnership. This depends on whether the income bracket for the partners is higher or lower than the partnership.
Comparing the US Approach to Other Countries’ Approaches in the World:
So far, it’s important to note that partnerships from a business organizational stand point are organized under the commercial code of the specific state in the United States—this is often akin or identical to the Uniform Commercial Code’s format and guided by case law. But there is no federal commercial code. The confluence with tax law comes in at the federal level. So, the partnership is organized under the laws of a specific state—which do vary state to state—and then have federal tax implications when qualifying for pass through taxation.
This approach is different in different countries. For example, Canada has a similar system to the US where there is provincial rules governing partnership formation; Sweden must register with the federal level of government; France allows partnerships to be flow through if the organization fits within the commercial law list of allowed partnerships; in the UK and Australia, partnerships are governed by common law; in the Netherlands the partnership is allowed if inverted under corporate rules—so sort of a side step approach; in Germany the partnership can be a flow through entity only under commercial law; and in Japan the system technically allows for partnerships, but they are hardly present.
Basic Structure Comparisons:
Per the basic structure of partnerships, most countries have some different domestic rules for determining opaqueness and flow through entities. In The Netherlands characterizes income to be determined at the individual level. Each partner can elect different schedules. The UK system has a scheduler system applied at the partnership level. Each partner pays a share, but asset sales are deemed to be made at the individual level.
Comparatively, in the US, the rules in Subchapter K are complex. Elections made at the partnership level. Capital gains and losses are at the individual level. The basis adjustments to the partnership shares are at the individual level as well. The rules allow for the use of capital accounts to reflect economic reality. There is no negative basis allowed. Similarly, Canada is similar to the US, but has simpler rules. Canada applies GAAR instead of the complex US rules when doing a “special allocation.” Moreover, Canada allows for a negative basis.
Sweden is similar to the US but has strict loss rules. It limits the use of losses to income of the partnership. Sweden also employs a scheduler system for business income. Arguably this is a simpler approach.
In Australia, the character of the income is determined at the partnership level with flow through taxation to the individuals. However, gains and losses are determined at the partner level.
Returning to Germany—with the highest level of partnerships of any country other than the United States—all elections, deductions, etc. are determined at the partnership level. There are no special allocations and the partnership agreements control the allocations. Partners losses cannot exceed a partner’s net equity.
In France, all elections are done at the partnership level. There are no special allocations allowed and the partnership agreement controls. There is no annual basis adjustment to shares allowed in the commercial code.
Liabilities – Tax Costs and Loss Limits:
Regarding liability, (i.e. tax costs of the partnership interest) and the loss limitations, the question to ask is what happens at the entity level (the Partnership) with liabilities? And, then how does this treatment impact two things: (1) the Basis in the partnership shares held by the partners (can I invest $10 and get $100 in return through losses); and, (2) What further impact does this have on the ability of the partners to take losses?
As a unique side note, Donald Trump made a lot of money in losses in real estate—whereby he took advantage of the rules allowing for losses allowed only to liability holders.
In the US, partnerships are reflected in the partner’s basis. General partners—not the limited partners—are labile, because they are at risk up to their investment in the partnership. However, there is a special rule for non-recourse debt (in other words, debt not backed by collar) whereby losses are allowed only to liability holders.
In the Netherlands—similarly to the US—partnership debt is considered the debt of the partner. However, there are not extremely detailed and complex rules at the US has.
In the UK, one follows the partnership agreement. Losses flow through the limited partner’s losses limited to the limited partner’s investment. But there can’t exist simultaneously some partners with profit and some partners with losses. Interestingly, there is no basis analysis—meaning the partnership basis is irrelevant to the partner’s basis.
Australia follows the partnership agreement—and like the UK cannot have some partners with profit and some partners with losses at the same time. Diverging from the UK, because of hybrids Australia has introduced new rules to adjust basis by risk and limit losses.
Canada’s partnership liability does not impact cost basis of a partner in the partnership. Limited partner losses are limited to basis in the general partner—who can take losses in excess of basis. This scenario with the general partner causes negative basis. Thus, at liquidation the general partner will have a larger gain in the end.
France has no limitation on losses from pass through entities—from the partnership to the partner. Sometimes scheduler limitations exist where R/E losses can not exceed R/E gains. Moreover, losses at the partnership level only considered at liquidations.
Finally, Germany—with its high level of partnerships—does not permit for partnership liability to adjust cost basis of the partner in the partnership. Furthermore, liability does impact determination of the limited partner’s equity and losses taken.
Japan has been missing from this discussion of partnership liability and structure before, because although Japan does have provisions for partnerships, they are virtually not existent. Historically, and from a policy perspective, Sweden had a history of tax shelter wars where much fraud occurred—causing Sweden to get rid of these rules.
In the United States, we have a complex set of partnership rules emanating from Subchapter K of the Internal Revenue Code.
The new tax proposal could change how deductions for partnership are made, interest expense limitations with debt-to-equity ratios, and how new CFC rules may affect foreign earnings.
However, even once these changes occur, it is important to note how they will interact with other systems in the world.
Political and Policy Denouement:
Looking to the future, it seems that events such as the Panama Papers, Lux Leaks, and now the Paradise Papers can lead to political motivation from NGOs in other countries. If one picks up the tabloids in other countries—such as the New York Post’s analogous publication in Australia—one will see the news of the latest movie star and right next to it how a major corporation is avoiding taxes.
To a US audience, this can seem foreign, because our major news sources, much less tabloids, do not often deal with these issues. But they can lead to political pressures in other countries—especially Europe that far outnumbers the US in the OECD. Then these political pressures can lead to domestic policies that then arise in the European Union’s policies—such as the EU state aid investigation cases affecting many US corporations operating—and then to the OECD level.
Indeed, what can be a better political strategy than raising taxes on corporations—who don’t vote in your country—to raise taxes and re-allocate spending within the specific country.
When the changes percolate to the OECD level, then the OECD can make monumental changes, such as the BEPS project that affect countries internationally.
So, several years later, such changes at the OECD level become parts of US tax reform domestically—as seen with the debt-to-equity ratios, etc. This often originates with major news items, such as Lux Leaks or the Panama Papers—more closely scrutinized by foreign audiences. Thus, it is important to look at the leaks, where the political pressure goes from those leaks, and then how that pressure can percolate up to the OECD level and ultimately influence US domestic rules and Senate Finance Committee Proposals. It’s all connected.
 § 42:2.Comparison of Subchapter S and Subchapter K, 13 Tex. Prac., Texas Methods of Practice § 42:2 (3d ed.)
 OECD/G20 Base Erosion and Profit Shifting Project Limiting Base Erosion Involving Interest Deductions and Other Financial Payments: Action 2: 2015 Final Report (OECD, 2015) http://www.oecd.org/ctp/neutralising-the-effects-of-hybrid-mismatch-arrangements-action-2-2015-final-report-9789264241138-en.htm
 Tax Cuts and Jobs Act, H.R. 1 (115th Cong. 1st Sess. 2017).
 (H.R. 1) http://src.bna.com/t9z
 OECD/G20 Base Erosion and Profit Shifting Project Limiting Base Erosion Involving Interest Deductions and Other Financial Payments: Action 4: 2015 Final Report (OECD, 2015) http://www.oecd.org/tax/beps/limiting-base-erosion-involving-interest-deductions-and-other-financial-payments-action-4-2016-update-9789264268333-en.htm
 An example of how this Double Irish Sandwich operates is as follows: “S1 transfers its headquarters to Bermuda, which has no income tax, thus becoming a Bermuda resident. Because of their different tax laws, the United States views the subsidiary as Irish but Ireland views the subsidiary as nonresident. S1 then licenses the IP to a wholly owned Irish subsidiary, "S2," which is not recognized as a corporation by the United States but is recognized by Ireland. The United States allows certain entities to elect to be classified as a corporation, partnership, or disregarded entity by "checking the box" on IRS Form 8832. Partnerships and disregarded entities are not recognized for U.S. tax purposes, and their assets and income are instead attributed to their parent corporation. S2 collects the income from the IP in Ireland, where it experiences a low tax rate, and is able to deduct the royalties it pays to S1 under Irish tax laws. This transaction is not taxed by the United States, as under U.S. law it is viewed as a transfer within a single Irish corporation. Thus, the royalties are untaxed but are deductible, and the IP income is taxed at a low rate. U.S. taxes are avoided.”
ARTICLE: TECHNOLOGICAL INNOVATION, INTERNATIONAL COMPETITION, AND THE CHALLENGES OF INTERNATIONAL INCOME TAXATION, 113 Colum. L. Rev. 347, 399
 Incidentally, Germany has the highest level of flow through entities out of any country in the world after the US, because 1930s National Socialist policy promoted that Germans to be “responsible” for their own activities and not hide behind a corporate shield—a good Nazi formed a partnership:
“"It took the Reichsfinanzhof, then the supreme German court for tax law, another eleven years to establish, in 1933, that GmbH & Co. KGs were to be taxed like ordinary partnerships, i.e. transparently, and not like corporations. However, the GmbH & Co. KG was truly kick-started, inadvertently, only by Nazi economic policy. According to Nazi ideology, a good German businessman should be personally liable. Limited liability was regarded as cowardly and immoral. Therefore, the Nazi regime wanted to encourage the transformation of closely held corporations, in particular GmbHs, into general partnerships. [emphasis added by author] In order to implement this policy, corporations were subjected to unrelieved and prohibitive corporate income taxation. At the same time, corporations were given the opportunity to convert into partnerships without negative tax consequences. " Erik Röder, Combining Limited Liability and Transparent Taxation: Lessons from the Convergent Evolution of GmbH & Co. KG,S Corporation, LLC and Co., Working Paper Max Planck Institute (2017).
 However, this is not the whole story. “If a partnership has a substantial built-in loss, the § 743(b) adjustments are mandatory. Id. § 743(a), (d). The total § 743 adjustment is the difference between the transferee partner's basis in his partnership interest and his share of the adjusted basis of the partnership property.” Jeffrey M. Colon, The Great Etf Tax Swindle: The Taxation of in-Kind Redemptions, 122 Penn St. L. Rev. 1, 68 (2017).