WRONGS AND REMEDIES: THE U.S. TAX TREATMENT OF MULTINATIONAL PARTNERSHIPS OF INDIVIDUALS

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1 WRONGS AND REMEDIES: THE U.S. TAX TREATMENT OF MULTINATIONAL PARTNERSHIPS OF INDIVIDUALS By Gregory May Gregory May is a partner with Freshfields Bruckhaus Deringer LLP. The author gratefully acknowledges the assistance of Robert Scarborough, Claude Stansbury, Adrian Boutel, and Eschrat Rahimi- Laridjani and the comments of members of the Washington International Tax Study Group to whom an earlier version of this report was presented in March Two recent rulings have prompted renewed discussion about the U.S. tax treatment of individuals in multinational partnerships, May believes. Revenue Ruling denied nonresident alien partners a treaty exemption from the U.S. tax on their shares of a partnership s U.S. business income. A contemporaneous private ruling revoked a controversial and inconsistent prior letter ruling. The rulings highlight, in May s view, the tax exposure for nonresident partners in multinational partnerships, but resident and citizen partners often encounter even greater exposure through gaps in the foreign tax credit system. This article reviews the tax difficulties confronted by both resident and nonresident individuals who belong to partnerships doing business internationally. It then discusses potential solutions under current law. Copyright Gregory May 2003 & All rights reserved. Table of Contents Perhaps it should not be surprising that partnerships of individuals actively engaged in international business confront difficult tax problems. Although multinational partnerships have played a role in the globalization of business throughout the late 20th century, they remain relatively uncommon and compared to multinational corporate business small. Even more to the point, their tax problems are granular. The individual partners rather than the enterprises themselves are the taxpayers. Most are professionals or bankers, the sort of busy people preoccupied with things more important than changing peculiar tax laws. This report attempts briefly to canvass the principal U.S. federal income tax issues confronting multinational partnerships of individuals doing business within the United States. 1 It first reviews the tax treatment of U.S. and non-u.s. partners in a single partnership. It next considers various arrangements a unitary partnership might adopt to improve the partners tax positions. It then concludes with a look at possible structural alternatives involving multiple partnerships. Throughout, it deals with typical paradigms and current law in the belief that complicated solutions tend to be unworkable and tax reform in this area should be left to those with great patience. 2 I. Unitary Partnerships To begin with the simplest case, consider a single general partnership that does business in several countries. Each partner is an individual actively engaged in the partnership s business. Each resides in the country where he or she works. The partnership agreement I. Unitary Partnerships A. Non-U.S. Partners B. U.S. Partners II. Unitary Partnership Adjustments A. Special Allocations B. Guaranteed Payments C. Tax-Adjusted Distributive Shares D. Reverse Hybrid Election III. Multiple Partnership Alternatives A. Parallel Partnerships B. Umbrella Structures IV. Adaptive Choices This report does not consider U.S. state tax issues. It also does not consider U.S. federal or state estate or inheritance tax issues that may arise when an individual who is not a citizen or resident of the United States dies while a partner in a partnership doing business within the United States. See sections 2101, 2104; Richard A. Cassell, Michael J.A. Karlin, Carlyn S. McCaffrey, and William P. Streng, U.S. Estate Planning for Nonresident Aliens Who Own Partnership Interests, Tax Notes, June 16, 2003, p Section references are to the Internal Revenue Code of For an excellent discussion of many of the same issues, see Kimberley S. Blanchard, The Unresolved Tax Status of Multinational Service Partnerships, 56 Tax Lawyer 779 (2003). TAX NOTES, June 21,

2 COMMENTARY / SPECIAL REPORT assigns each partner a stated percentage of the partnership s capital and income. The partnership has a fixed place of business in the United States. A. Non-U.S. Partners Individuals who are neither U.S. citizens nor U.S. residents must pay U.S. federal income tax only on their income from U.S. sources and any other income effectively connected with the conduct of a U.S. trade or business. 3 Non-U.S. partners are engaged in any U.S. trade or business conducted by the partnership. 4 Their shares of income effectively connected with the partnership s U.S. trade or business therefore are subject to tax on a net income basis. Under a limited force of attraction rule, any other nonperiodic income that a partner may receive from U.S. sources also is treated as effectively connected income. 5 The non-u.s. partners shares of each item of income, gain, expense, or loss from the partnership s U.S. trade or business is the portion commensurate with their percentage interests in the partnership. 6 The income has the same source and character in their hands as if they had received it directly. 7 Even if a non-u.s. partner performs services outside the United States, his or her share of the partnership s income from services performed by others within the United States is U.S.- source income. 8 A non-u.s. partner s gain on sale of a partnership interest is deemed to arise from the U.S. business to the extent attributable to the partnership s U.S. business assets. 9 A non-u.s. partner also is liable for income tax in the U.S. states and localities where the partnership conducts business Section Section Section 871(b); see section 864(c). 6 See sections 702, 704. Nonresident aliens are excepted from the allocation of worldwide interest expense generally required for U.S. tax purposes. In computing their net income, they take into account only the portion of partnership interest expense equal to the portion of partnership assets generating income effectively connected with the U.S. business. They can deduct only interest expense arising from liabilities entered on the books of the U.S. trade or business when incurred or secured by assets generating income effectively connected with the U.S. trade or business (and then only to the extent they do not exceed 80 percent of the assets of the U.S. trade or business and are not collateralized by other assets). See Treas. reg. section T(d)(2), (e)(3), and (e)(7). 7 Sections 702(b), 875(1); Treas. reg. section (b). Nonresident alien partners can claim credit against their U.S. tax liability for certain foreign taxes on income effectively connected with the partnership s U.S. trade or business, but generally not for taxes imposed by their residence country. See section See Foster v. Comm r, 329 F.2d 717 (2d Cir. 1964); Foster v. Comm r, 42 T.C. 974 (1964); Rev. Rul , C.B. 290; Rev. Rul , C.B. 188 (Situation 1). 9 Rev. Rul , C.B. 107; see sections 731 and 736(b) (payments to retiring partners), 897(g) (gain attributable to partnership s U.S. real property). 10 See, e.g., N.Y. Tax Law section 632 (Consol. 2004). Unless their residence country unilaterally allows relief for U.S. subnational taxes, non-u.s. partners may suffer double taxation to some extent because the double taxation article of U.S. tax (Footnote 10 continued in next column.) The partnership must withhold U.S. federal income tax quarterly on the non-u.s. partners shares of the net income from its U.S. businesses. 11 The withholding is at the highest marginal tax rate. 12 Each non-u.s. partner must file a U.S. federal income tax return to report all income subject to U.S. tax on a net income basis. 13 There is no provision for a unitary filing by nonresident partners. 14 On their returns, partners may claim credits or refunds for tax withheld by the partnership. 15 Non-U.S. partners usually encounter various discrepancies between their U.S. and residence country tax accounts. In the United States, partnerships of individuals typically use the calendar year as their fiscal year and keep accounts in U.S. dollars. 16 Service partnerships commonly use the cash method of accounting. 17 In their residence countries, partners often must use a different fiscal year and keep accounts in the local currency using an accrual method of accounting. Non-U.S. partners typically obtain little benefit from tax treaties in this situation. Treaties permit the source country to tax business profits attributable to a local permanent establishment and income from independent treaties generally requires the other state to provide relief only for U.S. federal taxes. See U.S. Model Income Tax Treaty, arts. 2 and 24(6) (1996) (hereinafter 1996 U.S. Model Treaty). 11 Current Treasury regulations say all interest paid by a partnership engaged in a U.S. trade or business arises from U.S. sources, so a non-u.s. partnership may be required to withhold U.S. tax from interest payments having no connection to its U.S. business unless an exemption applies. Treas. reg. section (a)(2). Pending legislation would treat interest paid by a partnership predominantly engaged in active business outside the United States as foreign-source interest except to the extent allocable to a U.S. trade or business. Jumpstart Our Business Strength Act of 2004, S. 1637, 108th Cong. section 228 (2004). 12 Section 1446(a)-(b); prop. Treas. reg. sections , -2, and -3; Rev. Proc , C.B. 895, modified by Rev. Proc , C.B The partnership also must file a U.S. federal income tax return. Section In a few cases, the partnership may be required to withhold state income taxes. See Cal. Rev. and Tax. Code section (Deering 2004); Cal. Code Regs. tit. 18, sections , (1998) (domestic nonresident partners); N.Y. Tax Law section 658(c)(4) (nonresident partners) (Consol. 2004); Pa. Stat. Ann. tit. 72 section 7324 (West 2004) (nonresident partners). 13 Section In its report on article 14 of the OECD Model Tax Convention, the OECD Committee on Fiscal Affairs suggested unitary filing as a remedy for the compliance burden on multinational partnerships and cited section 1141(a) of the Taxpayer Relief Act of 1997 as the basis on which the U.S. Treasury expected to provide for unitary filing. OECD Comm. on Fiscal Affairs, Issues Related to Article 14 of the OECD Model Tax Convention par. 43 (2000). Section 1141(a) of the 1997 act added section 6031(e), which authorizes the Treasury to provide simplified procedures for filings by foreign partnerships. The Treasury issued regulations setting out those procedures in 1999 without giving any indication that it was considering unitary filing for foreign partners under section See T.D. 8841, 64 Fed. Reg. 61, 498 (Nov. 12, 1999). 15 Section 1446(d); Rev. Proc , C.B. 895, section See sections 444(e), 706(b), 985(b). 17 See sections 446(c), 448(b)(2) TAX NOTES, June 21, 2004

3 services attributable to a local fixed base. The partnership s U.S. office will give each partner a permanent establishment or a fixed base. 18 The amount of income attributable to the permanent establishment or fixed base under a treaty, and therefore subject to U.S. tax on a net income basis, generally will be the same as the income effectively connected with the U.S. trade or business under domestic law. Only nonperiodic U.S. source income associated with the U.S. trade or business under the limited force of attraction fiction enjoys treaty relief because it typically is not attributable income. 19 Treaties provide no protection from income tax imposed by the U.S. states. 20 The typical independent personal services article in U.S. tax treaties has been said to prevent the United States from taxing non-u.s. partners in service partnerships who do not themselves perform services within the United States. But if the U.S. tax authorities ever did accept that position, it is clear they no longer do. The IRS recently published a ruling taking the position that a typical independent personal services article permits the United States to tax nonresident partners on their shares of income from a U.S. trade or business whether or not they ever work in the United States. 21 While the U.S. position sometimes has seemed ambiguous, the ruling is not new law. The typical independent personal services article allows the source country to tax income attributable to a fixed base only if it arises from services performed within 18 Unger v. Comm r, 936 F.2d 1316 (D.C. Cir. 1991); Donroy, Ltd. v. United States, 301 F.2d 200 (9th Cir. 1962); Rev. Rul , C.B. 170 (Situation 1); Rev. Rul , C.B. 187; 1996 U.S. Model Treaty, arts. 5, 7, and 14; see OECD Model Tax Convention, arts. 5 and 7 (2003) [hereinafter 2003 OECD Model Treaty]. 19 See 1996 U.S. Model Treaty, art. 7(1); 2003 OECD Model Treaty, art. 7(1); U.S. Treas. Dep t, Tech. Expl. of U.K.-U.S. Income Tax Treaty, art. 7(1) (Mar. 5, 2003) (income from U.K. partner visiting United States to work on U.S. office matter); U.S. Treas. Dep t, Tech. Expl. of 1996 U.S. Model Income Tax Treaty, art. 7(2) (Sept. 20, 1996); Richard Andersen, et al., Analysis of United States Income Tax Treaties par. 4.02[1][b][ii], available at riag.com (hereinafter Andersen, U.S. Income Tax Treaties) (tax treaties negotiated after 1963 override the force of attraction principle). 20 A non-u.s. partner entitled to treaty protection may suffer double taxation if his or her residence country treats partnership income taxed by the United States as arising from sources in the residence country. Not all U.S. income tax treaties contain a resourcing provision that requires each country to treat income taxed by the other as foreign-source income. E.g., Income Tax Treaty, July 24, 2001, U.K.-U.S., art. 24(2) and (5) (resourcing provisions); Income Tax Treaty, Aug. 29, 1989, Ger.-U.S., art. 23(2) and (3)(c) (resourcing provisions). Compare 1996 U.S. Model Treaty, art. 23 (no resourcing provision) with U.S. Treas. Dep t, Model Income Tax Treaty, art. 23(3) (1981) (resourcing provision). 21 Rev. Rul , IRB 486, Doc , 2004 TNT COMMENTARY / SPECIAL REPORT the country. 22 The rule clearly applies to sole practitioners, but not so clearly to partners in professional service partnerships. In a much discussed 1993 private letter ruling to a German law firm, however, the IRS said that the independent services article in the German-U.S. treaty prevented the United States from taxing the nonresident partners who had performed no services in the firm s U.S. office because they personally had no U.S. fixed base. The ruling said the firm had allocated all profits from its U.S. office to the resident partner, so the ruling arguably could have turned on the view that the nonresident partners did not share in income from services performed there. But that was not the stated rationale. 23 Treasury s technical explanation of the 1996 Model Income Tax Treaty showed sympathy for the position in the private ruling, but it distinguished a partner s remuneration for his or her own services from the partner s share in income from partnership capital or the services of partnership employees. It said that income from a partner s own services should be taxed only where he or she works, while a partner s share of other partnership income would not be protected by the independent personal services article. 24 The explanation might be read to suggest that all of a partner s income could be treated as remuneration for his or her own services if the partnership agreement so provided. Any suggestion to that effect, however, almost certainly referred to situations where a nonresident partner receives a guaranteed payment rather than (or in addition to) a profit share. 25 Read against the technical explanation s statement that partnership income not arising from the partner s own services is not governed by the independent personal services article, the explanation seems to say that at least part of a profit share from a service partnership would be treated as business profits. 26 Treasury s subsequent technical explanation of the Swiss-U.S. tax treaty was clearer and different, but to the same effect. While acknowledging that the independent personal services article would 22 See, e.g., 1996 U.S. Model Treaty, art. 14; Income Tax Treaty, April 3, 1996, Lux.-U.S., art. 15(1); Income Tax Treaty, Aug. 29, 1989, Ger.-U.S., art. 14(1); cf. Income Tax Treaty, Dec. 18, 1992, Neth.-U.S., art. 15(1) (attributable to fixed base and not performed in the other country); Income Tax Treaty, Aug. 31, 1994, Fr.-U.S., arts. 14(4) and 23(4) (50 percent limitation on French exemption for income earned by French resident partner with related reduction to French-source income of other partners). 23 LTR , 93 TNT , revoked by LTR , Doc , 2004 TNT 95-44; see infra Part II.A (special allocations). Private letter rulings are not authority on which other taxpayers may rely, although they may provide insight into the IRS s analysis of applicable authority. 24 U.S. Treasury Dep t, Tech. Expl. of 1996 U.S. Model Income Tax Treaty, arts. 7(7) and 14(1) (Sept. 20, 1996). 25 Guaranteed payments for services probably arise where the services are performed. Profit shares, on the other hand, have the same sources as the income out of which they come. See supra text accompanying notes 3-6; infra text accompanying notes 88 and See 1996 U.S. Model Treaty, arts. 7(7) and 7(8). TAX NOTES, June 21,

4 COMMENTARY / SPECIAL REPORT govern taxation of profit shares from service partnerships, it flatly stated that nonresident partners would be taxed on their shares of profits attributable to a fixed base even if they personally never perform services there. 27 The OECD Committee on Fiscal Affairs has taken the same position on the attribution of a fixed base to nonresident partners. In a 1999 report on the application of the OECD Model Tax Convention to partnerships, most OECD member countries indicated that they recognized the source country s right to tax attributable profits whether or not the nonresident partner actually used the fixed base. 28 In 2002, the committee removed the independent personal services article from the OECD model treaty on the ground that the business profits article should apply to independent services income. Brushing aside the suggestion that a fixed base could not be attributed to all partners in the same way that a permanent establishment can be, the committee said the change reflected the understanding that the two articles had been intended to produce the same results in any event. 29 By that time, the United Kingdom and the United States already had taken the same approach in their 2001 treaty. The treaty omitted the independent personal services article, and the Treasury s technical explanation made clear that each country may tax nonresident partners on income attributable to a local permanent establishment of a service partnership. 30 Against this background, the Service s recent ruling that the United States can tax nonresident partners on income attributable to a fixed base they never visited and its contemporaneous revocation of the inconsistent 1993 private ruling 31 was no surprise. B. U.S. Partners Partners who are U.S. citizens or U.S. residents must pay U.S. federal income tax on their worldwide income on a net income basis. 32 Each U.S. partner must take into account his or her share of the partnership s items of income, gain, deduction, loss, or credit. 33 U.S. partners also are liable for income tax in the U.S. states where they reside and, in most cases, where the partnership does business. Their U.S. income tax concerns therefore relate not to limits on U.S. tax jurisdiction, but to relief from double taxation. Relief depends on the availability of 27 U.S. Treas. Dep t, Tech. Expl. of Switz.-U.S. Income Tax Treaty, art. 14. The technical explanations of other recent U.S. income tax treaties with independent personal service articles contain no comparable statement. See, e.g., U.S. Treas. Dep t, Tech. Expl. of Lux.-U.S. Income Tax Treaty, art. 15; U.S. Treas. Dep t, Tech. Expl. of Ital.-U.S. Income Tax Treaty, art OECD Comm. on Fiscal Affairs, The Application of the OECD Model Tax Convention to Partnerships, paras (1999). 29 OECD Comm. on Fiscal Affairs, Issues Related to Article 14 of the OECD Model Tax Convention, paras (2000). 30 U.S. Treas. Dep t, Tech. Expl. of 2001 U.K.-U.S. Income Tax Treaty, art. 7(1). 31 LTR , note 23 supra (revocation letter granting section 7805(b) relief dated Jan. 30, 2004, the day after issuance of Rev. Rul ). 32 Section 61(a). 33 Sections 702, 704; see section 703(b)(3) (foreign tax credit elections to be made by each partner). foreign tax credits and treaty benefits. A partner s access to foreign tax credits can be jeopardized by limitations under domestic law as well as inconsistent source or qualification determinations under the laws of the various countries where the partnership operates. U.S. partners can lose treaty benefits if the source country does not allow them to claim benefits for their shares of partnership income or allocates income among partners differently than it has been allocated for U.S. tax purposes. The U.S. domestic law issues tend to be the more complicated. 1. Foreign tax credit limitations. Domestic law restrictions on the ability to claim foreign tax credits or other unilateral double taxation relief are the more frequent practical concern. To begin with, the U.S. states and localities that impose income or equivalent taxes generally offer neither tax credits nor deductions for income taxes paid to foreign jurisdictions. 34 U.S. partners therefore suffer some double taxation in relation to the portion of their overall tax liability represented by state and local taxes. The burden is not inconsiderable for partners who pay state tax at high marginal rates. 35 Federal law offers tax credits or deductions for income taxes imposed by foreign countries and their political subdivisions. 36 The basic limitation on the credit appears simple enough. A U.S. partner may not credit foreign taxes against U.S. federal income tax liability to the extent they exceed the U.S. tax on his or her net income from foreign sources. 37 But four major features of the rules for computing income from foreign sources and the restrictions on the use of foreign tax credits effectively prevent the U.S. foreign tax credit system from providing adequate relief from double taxation in many cases. a. Apportioning deductions. The U.S. partner s net income from foreign sources as computed for foreign tax credit purposes generally will be less than the net income taxed under foreign law. The reduction in foreign-source 34 See, e.g., N.Y. Tax Law sections 615(c)(1), 620 (Consol. 2004). 35 See, e.g., N.Y. Tax Law section 601 (7.7 percent New York State tax); N.Y. City Admin. Code section (3.2 percent New York City tax). New York City also imposes a 4 percent unincorporated business tax directly on partnerships doing business there. N.Y. City Admin. Code section (2001). The federal itemized deduction for state and local income taxes reduces the effective burden, but high-income taxpayers can lose up to 80 percent of their federal itemized deductions. See sections 68, 164. Taxpayers subject to the alternative minimum tax can claim no deduction for state or local taxes. Section 56(b)(1)(A); see infra text accompanying note Sections 164(a)(3), 901; Treas. reg. section (g)(2). 37 Statute limits the amount of the foreign tax credit to the same proportion of the taxpayer s U.S. federal income tax liability for the relevant period as the taxpayer s foreign-source taxable income bears to the taxpayer s worldwide taxable income. Section 904(a). The limitation applies separately to 10 specified categories of income, and a partner s share of partnership income must be separated into those categories. Sections 702(a)(6)-(7) and (b), 904(d); Treas. reg. section (a)(8)(ii) and (b). As a practical matter, the income of most multinational partnerships typically falls into one of five categories: passive income, high withholding tax interest, financial services income, shipping income, or general income (the residual category) TAX NOTES, June 21, 2004

5 net income increases the likelihood that foreign tax will have been imposed at an effective rate higher than the U.S. rate. Three rules cause the reduction. The first rule requires a U.S. partner to apportion most itemized deductions between foreign- and U.S.-source income on a pro rata basis. The apportionable deductions are those for qualified residence interest, charitable contributions, real estate and property taxes, medical expenses, and alimony payments. 38 Since other countries in which the partnership does business almost certainly would not have allowed these deductions, apportioning any part of them to foreign-source income will increase the effective foreign tax rate. A second rule requires a U.S. partner to apportion the deduction for state taxes between foreign- and U.S.- source income. This rule introduces an additional distortion because it presumes that the state taxes attributable to foreign-source income are only those imposed on the amount by which state taxable income exceeds federal taxable income from U.S. sources. 39 Most states determine taxable income by adjusting federal taxable income for various items, so discrepancies between taxable income for state and federal purposes are routine. State taxable income tends to exceed federal taxable income primarily because the states add back tax-exempt interest and reduce various federal deductions (such as the deduction for accelerated depreciation). The presumption therefore tends to attribute too much state tax to foreign-source income and further inflate the effective foreign tax rate as computed for foreign tax credit purposes. A third rule requires a U.S. individual to apportion business interest expense, including his or her share of interest expense from a general partnership. Business interest is apportioned between U.S.- and foreign-source income based on the relative fair market or tax book values of all assets used in U.S. and foreign business activities, including the partner s share of the partnership s business assets. 40 The rule implements a fungibility of money principle scarcely ever accepted outside the United States, thus exacerbating the discrepancy between foreign-source income as determined under U.S. and foreign law. The effect depends on where business assets are located, whether the partner has more than one business, and whether the partnership is more or less leveraged than the partner s other businesses. The effect is particularly unpredictable in the case of service partnerships and other partnerships with significant unprotected know-how because their incomes bear little relation to the value of their assets. b. Timing mismatches. The foreign taxes paid during a particular tax year generally will not relate to the foreign-source income recognized during the year. The mismatch arises from differences in tax years, methods of accounting, or tax payment dates. For U.S. federal income tax purposes, an individual generally pays tax on income recognized on a cash basis during the calendar 38 See Treas. reg. sections (e)(9), T(d)(1)(iv). 39 See Treas. reg. section (e)(6)(i) and (ii)(c). 40 See Treas. reg. section T(d)(1)(i) and (e)(3). COMMENTARY / SPECIAL REPORT year. 41 A partnership of individuals must use the calendar year for tax purposes unless it establishes a sufficient business reason for an exception. 42 The partnership may adopt an accrual or other proper method of tax accounting, but U.S.-based service partnerships typically use the cash method. The individual partners recognize their shares of partnership income in their individual tax years during which the partnership s tax year ends. 43 In other countries, the tax year for individuals may be a fiscal year other than the calendar year, and partnerships may use different tax years. Partnerships often must keep their accounts on an accrual basis. Perhaps most importantly, tax for the year may not be determined and paid until the calendar year following the calendar year during which the partnership s fiscal year ended. 44 In those situations, the amount of income that a U.S. partner in a partnership using the cash basis recognizes for a particular year will differ from the amount on which the foreign country imposes tax. If the partnership observes a calendar year for U.S. tax purposes, the U.S. partner must recognize the income even though the foreign fiscal year does not end until the following calendar year. And the U.S. partner may not claim credit for foreign taxes on that income until they have been paid in some subsequent year. If a U.S. partner s share of partnership income is increasing or the partnership s net income is growing, the U.S. partner in any calendar year will recognize income greater than that on which the foreign tax it recognizes was imposed. The available tax credit therefore will be insufficient unless, by chance, the effective foreign tax rate was high enough in the previous years to which the tax paid during the year related. The partnership can mitigate these problems by adopting an accrual method of accounting, which permits partners who otherwise use the cash basis of accounting to recognize their shares of partnership items on the accrual basis. 45 But a change from the cash to the accrual method generally requires the partnership to accelerate income to effect the change as well as thereafter. 46 The partnership or the partner can claim more targeted relief by electing to accrue foreign taxes while otherwise remaining on the cash method. 47 c. Currency gain and loss. A U.S. partner must recognize foreign currency gains and losses that will not be taken into account for non-u.s. tax purposes. The difference between the amounts of income recognized 41 See sections 441(g), 446, Section 706(b)(1); see section 444(b). 43 Section 706(a). 44 In the United Kingdom, for example, an individual partner s year of assessment typically ends on April 5, the partner takes into account partnership income for the partnership accounting period ended during that year and the partner need not pay tax due on the income until the following January Section 446(c)-(d); Treas. reg. section (c)(1)(iv)(b) and (d). 46 See generally section 481; Rev. Proc , C.B. 680, Doc , 97 TNT 90-8, modified by Rev. Proc , IRB 696, Doc , 2002 TNT Section 905(a); see section 703(b)(3); Treas. reg. section (b)(2)(i). TAX NOTES, June 21,

6 COMMENTARY / SPECIAL REPORT and foreign tax paid for U.S. and non-u.s. tax purposes changes the effective rate of foreign tax borne by the U.S. partner for U.S. tax purposes. Much depends on the volatility of the relevant currencies against the U.S. dollar and the speed at which the partnership distributes its earnings. The partnership and each branch that keeps separate business records is a qualified business unit, and a qualified business unit operating outside the United States typically will have a functional currency other than the U.S. dollar. 48 Qualified business units that do not use the U.S. dollar as their functional currency generally must compute their taxable income or loss in their functional currency and then translate the result into U.S. dollars at the average exchange rate for the tax year. 49 A U.S. partner uses the amount determined at the average exchange rate to compute its share of partnership income. For purposes of the foreign tax credit, however, foreign taxes on the qualified business unit s income are translated at the spot rate on the date when the taxes are paid or accrued. 50 When the partnership receives a remittance from a branch with a different functional currency, it generally recognizes foreign currency gain or loss equal to the difference between the spot value of the remittance and the average rate at which the partnership accounted for its interest in the branch and the branch earnings. Likewise, when the U.S. partner receives a distribution from a partnership with a functional currency other than the U.S. dollar, the U.S. partner generally recognizes foreign currency gain or loss equal to the difference between the spot value of the distribution and the average value at which the partner accounted for its investment in the partnership and its share of partnership income. The currency gain or loss typically arises from foreign sources in proportion to the value of the qualified business unit s assets that produce foreignsource income. 51 The effective rate of foreign taxation for U.S. purposes therefore depends on differences between the average rate for the tax year, the spot rate at which foreign taxes are paid, and the spot rate when remittances and distributions are made. d. Alternative minimum tax. The alternative minimum tax regime imposes an additional limitation on U.S. partners foreign tax credit claims. Taxpayers must pay the alternative minimum tax to the extent their tentative 48 Sections 985(b), 989(a); Treas. reg. sections (b), 1.989(a)-1(b)(2). 49 Sections 987, 989(b)(4); prop. Treas. reg. section (b)(1) (profit and loss method). 50 Prop. Treas. reg. section (b)(3). 51 Section 987(3); Treas. reg. section T(d)(1)(i), (e)(3), and (g); prop. Treas. reg. section (d) and (f). Remittances or distributions that are treated as dispositions or terminations of a qualified business unit give rise to foreign currency gain or loss on the investment in the unit, but the proposed Treasury regulations have reserved on the application of those rules to partnerships. See prop. Treas. reg. section (a) and (e); 56 Fed. Reg. 48,457 (Sept. 25, 1991) (preamble silent on application of termination rules to partnerships). minimum tax exceeds their regular tax for the year. An individual s tentative minimum tax is determined by applying minimum rates of 26 or 28 percent to taxable income as recomputed without the benefit of various tax preferences, such as some tax-exempt interest exclusions, accelerated depreciation deductions, state and local tax deductions, and interest deductions. 52 Foreign tax credits cannot offset more than 90 percent of the tentative minimum tax. 53 This alternative foreign tax credit limitation affects U.S. partners whenever their taxable income, as redetermined under the alternative minimum tax rules, bears foreign tax at an effective rate greater than 90 percent of the U.S. rate. Expatriates fully subject to tax abroad are most obviously affected. Their foreign tax credit claims can bring them into the alternative minimum tax regime if the effective foreign tax rate exceeds 90 percent of the effective U.S. federal tax rate. 54 But the limitation also can affect U.S. resident partners whose other tax preferences have subjected them to alternative minimum tax. In practice, partners often fall into the regime if they pay state and local tax at high rates, pay interest on supplemental borrowings secured by their residence, or claim accelerated depreciation from other investments. The courts have found the alternative minimum tax foreign tax credit limitation compatible with U.S. treaty obligations to relieve double taxation, 55 and at least one recent U.S. tax treaty expressly recognizes that. 56 Legislative proposals to remove the limitation so far have not been enacted Treaty benefits. A U.S. partner that loses benefits under an income tax treaty can suffer double taxation either because the United States takes the view that the tax could have been avoided or because the resulting foreign tax exceeds the U.S. tax on the partner s foreignsource income. The first situation can arise when a 52 Sections 55(b)(1)(A), 56(a), and (b). 53 Section 59(a)(2). Excess foreign tax credits may be carried backwards or forwards under normal rules. Id. 54 Expatriate U.S. partners are entitled to exclude $80,000 of foreign earned income from gross income. Section 911. See infra text accompanying notes 88 and E.g., Kappus v. Comm r, 337 F.3d 1053, Doc , 2003 TNT (D.C. Cir. 2003) (Canadian-U.S. treaty); Pekar v. Comm r, 113 T.C. 158, Doc , 1999 TNT (1999), acq. on another issue IRB 606, Doc , 2002 TNT (German-U.S. and UK-U.S. treaties); Lindsey v. Comm r, 98 T.C. 672, 92 TNT (1992), aff d 15 F.3d 1160, Doc , 94 TNT 33-5 (D.C. Cir. 1994) (unpubl.) (Swiss-U.S. treaty); Price v. Comm r, 84 T.C.M. (CCH) 250, Doc , 2002 TNT (2002) (Canadian-U.S. treaty). 56 Income Tax Treaty, Italy-U.S., Aug. 25, 1999, art. 23(2)(a) (not yet in force). See also U.S. Treas. Dep t, Tech. Expl. of 2001 U.K.-U.S. Income Tax Treaty, art. 24(1). 57 See Jumpstart Our Business Strength Act of 2004, S. 1637, 108th Cong. section 203 (2004); Fairness, Simplification and Competiveness for American Business Act of 2003, H.R. 285, 108th Cong. section 206 (2003); Fairness, Simplification and Competitiveness for American Business Act of 2002, H.R. 4151, 107th Cong. section 206 (2002); S. 801, 107th Cong. section 1(a) (2001) TAX NOTES, June 21, 2004

7 partnership composed of partners from multiple jurisdictions simply fails to pursue the treaty relief to which the U.S. partners, who may receive a relatively small proportion of the partnership s income, are entitled. The partnership will have failed to pursue treaty relief for this purpose not only when it fails to claim refunds or reductions of source-country tax, but also when it fails to contest reallocations or recharaterizations of income that inappropriately (from a U.S. point of view) increase source-country tax. 58 The second situation can arise in at least two ways. The source country can treat the partnership as an entity not resident in the treaty country because it is not liable to tax, or the source country can treat the partnership as an aggregate but not allow partners themselves to claim treaty benefits on their shares of partnership income. U.S. partners should not often encounter this difficulty if the partnership s income arises in developed countries. Most OECD member countries have subscribed to the 1999 report on application of the OECD model treaty to partnerships, which interprets the standard residence article as extending treaty benefits to partnership income allocated to partners who are residents of the treaty country. 59 The source country also can allocate income among partners differently than it is allocated for U.S. tax purposes. This should rarely happen when the partnership agreement allocates income straightforwardly and allocations remain constant during the relevant tax period. But it easily might happen when partnership allocations are complex or when the partnership attempts to allocate income based on its source. II. Unitary Partnership Adjustments The allocation of income by source is one of several expedients a multinational general partnership might adopt to ameliorate its partners U.S. tax difficulties. Guaranteed payments, tax-adjusted distributive shares, and reverse hybrid elections are others. A. Special Allocations The partners in a multinational partnership could avoid many tax difficulties if each received only income from partnership operations in the country where he or she resides. To that end, the partnership might allocate the income from each national operation to the local partners to the extent possible. Partners in countries where the partnership s profits cover local partners distributions would receive only local-source income. Partners in other countries would receive some foreign income but less than they would have received had all partners received their shares of worldwide income. The partnership might adopt even more complicated allocations. For example, the partnership agreement might provide that partners profit shares would be reduced to the extent local profits are insufficient to fund distributions of the amounts to which they otherwise would have 58 See Treas. reg. section (e)(5)(i) and (ii), Example OECD Comm. on Fiscal Affairs, The Application of the OECD Model Tax Convention to Partnerships, par. 35 (1999). France, the Netherlands, and Portugal expressed reservations. Id., Annex II. COMMENTARY / SPECIAL REPORT been entitled. The partnership could retain the income from countries with excess earnings or use it to make returns of capital. 60 Partners whose entitlements were reduced could receive compensating distributions in later years when local income was sufficient. Alternatively, the partnership agreement might provide that partners can receive their shares only from local profits without the possibility of compensating distributions in later years. Under either alternative, liquidating distributions would be in accordance with capital accounts. Special allocations could help both U.S. and non-u.s. partners. Assuming the special allocations based on source were respected for U.S. tax purposes, non-u.s. partners with no share in the income from U.S. operations would have no U.S. tax liability because although engaged in a U.S. trade or business they would receive no income effectively connected with that business. They would have to file U.S. federal income tax returns, but they would report no taxable income on them. If the special allocations also were respected for non-u.s. tax purposes, U.S. partners with no share in the income from non-u.s. operations would incur no foreign tax and suffer no exposure to double taxation. 61 The allocation of income by source is one of several expedients a multinational general partnership might adopt to ameliorate its partners U.S. tax difficulties. Whether source-based special allocations are effective for U.S. federal income tax purposes depends on the circumstances. Special allocations generally are ineffective unless they have substantial economic effect or they are in accordance with the partners real interests in the partnership. 62 Treasury regulations elaborate those concepts in exhausting detail, but the fundamental points relevant here are relatively few. An allocation has economic effect if it affects the partners relative interests in the partnership as reflected in their capital accounts and their rights to partnership income or assets. 63 The economic effect is substantial, however, only if there is a 60 Returns of capital to partners whose distributions were reduced for lack of locally sourced income would be treated as guaranteed payments to the extent they substituted for reduced distributions. See generally Miller v. Comm r, 52 T.C. 752, (1969), acq C.B. 2 (discussing Lloyd v. Comm r, 15 B.T.A. 82 (1929)); infra text accompanying notes U.S. partners would benefit similarly if they could receive selective allocations of only the types of foreign-source income that bear tax at effective rates lower than the effective U.S. federal income tax rate on the partners worldwide income. 62 Section 704(b)(2); Treas. reg. section (b)(1)(i). 63 See Treas. reg. section (b)(2)(ii). The regulations establish three requirements for demonstrating that an allocation actually affects the partners economic benefits or burdens: (i) the partnership must maintain capital accounts that properly reflect allocations and distributions, (ii) liquidating distributions must be made in accordance with capital accounts, and (iii) either partners must restore deficits in their capital accounts on (Footnote 63 continued on next page.) TAX NOTES, June 21,

8 COMMENTARY / SPECIAL REPORT reasonable possibility that it will substantially affect the dollar amounts that partners receive from the partnership independent of tax consequences. An allocation that enhances the present value of any partner s after-tax return also does not have substantial effect unless there is a strong likelihood that it substantially will diminish the present value of another partner s after-tax return. 64 The allocation of one type of income does not have substantial effect if allocations of other types of income during the same partnership year are very likely to offset it. 65 An allocation during one partnership year does not have substantial effect if allocations during other years are very likely to offset it. 66 An example in the Treasury regulations applies the substantial economic effect rules to allocations of income based on source. The example says that allocations of domestic income to each partner are not substantial when partners are entitled to stated percentages of overall partnership income and income from the relevant countries likely will be sufficient to satisfy each partner s entitlement from domestic income. 67 If, in contrast, partners are entitled to different percentages of the income from domestic and foreign sources and they are not likely to receive the same amounts they would have received had they been entitled to shares in partnership income from all sources, the allocation does have substantial effect. 68 An allocation that lacks substantial economic effect may be respected for federal income tax purposes if it is in accordance with the partners interests in the partnership. But that likely does not meaningfully amplify the scope for source-based allocations of income. Among the relevant indicators of the partners interests in the partnership are their relative contributions to the partnership, interests in economic profit and loss, interests in cash flow and nonliquidating distributions, and interests in liquidating distributions. 69 An allocation is not in accordance with the partners interests in the partnership unless it shifts the real economic benefits and burdens of the item allocated. The decision on whether an allocation is in accordance with the partners interests obviously depends heavily on the particular facts, 70 and the decided cases have turned on relatively simple determinations that provide scant liquidation or the allocation must not create a capital account deficit taking into account certain special adjustments and income offsets. Id. section (b)(2)(ii)(b) and (d). 64 Treas. reg. section (b)(2)(iii)(a) (the so-called dollar amount and overall present value tests); see infra text accompanying notes Treas. reg. section (b)(2)(iii)(b) (shifting allocations). 66 Treas. reg. section (b)(2)(iii)(c) (transitory allocations); see section (b)(5), Example 8(ii). 67 Treas. reg. section (b)(5), Example 10(ii). 68 Treas. reg. section (b)(5), Example 10(i). 69 Treas. reg. section (b)(3)(ii). 70 See Lawrence Lokken, Partnership Allocations, 41 Tax L. Rev. 547, 614 (1986) ( meaningful generalization about the application of these factors is not possible ). guidance. 71 When an allocation lacks economic effect, it generally will not be in accordance with the partners interests in the partnership. 72 Even when an allocation with economic effect simply lacks substantiality, there is little room for it to be in accordance with the partners interests. An allocation of one type of income to one partner offset by the allocation of another type of income to another partner does not really change the interests of partners who otherwise have stated percentage interests in the partnership. 73 Similarly, an over- or underallocation of income in one year does not affect the partner s interests when the partnership in fact receives sufficient income to make offsetting special allocations to the other partner in later years. 74 Under the standards in the Treasury regulations, the simplest special allocation mentioned which satisfies a partner s income entitlement from local profits to the extent possible seems neither to have substantial economic effect nor to be in accordance with the partners interests in the partnership because each partner receives the same amount of income regardless of source. The second special allocation which reduces shares when local profits fall short but provides for subsequent compensating distributions also would not seem to have substantial economic effect or to be in accordance with the partners interests in the partnership if there is a strong likelihood of compensating distributions. But the third special allocation which truncates shares without the possibility of subsequent compensating distributions does have substantial economic effect because partners working in countries where profits are below average receive less partnership income. Were the third special allocation applied only to partners in countries where local income is quite likely to cover the local partners distributions, however, the allocation probably would not have substantial economic effect. 75 Even if compensating distributions are likely, the allocation arguably is in accordance with the partners 71 See Richard M. Leder, Tax-Driven Partnership Allocations With Economic Effect: The Overall After-Tax Present Value Test for Substantiality and Other Considerations, 54 Tax Lawyer 753, (2001). 72 See, e.g., Ogden v. Comm r, 788 F.2d 252 (5th Cir. 1986) (allocation lacked economic effect because partnership to liquidate in accordance with stated percentages, which represented the partners real interests in the partnership). Compare Treas. reg. section (b)(2)(i) (residual test for economic effect) with Treas. reg. section (b)(3)(iii) (hypothetical liquidation test for partners interests in the partnership). 73 See Treas. reg. section (b)(5), Example 10(ii); cf. Rev. Rul , C.B. 506, Doc , 1999 TNT (allocation of income offset by allocation of book losses from revaluation). 74 Treas. reg. section (b)(5), Example 8(ii). 75 Cf. Treas. reg. section (b)(5), Example 5 (strong likelihood special allocations of taxable and tax-exempt income would not reduce overall after-tax consequences of any partner). A short-lived old revenue ruling concluded that when partners shared profits from a domestic and a foreign operation in different percentages, the partners had two partnerships for tax purposes. Rev. Rul , C.B. 649, revoked by Rev. Rul , C.B TAX NOTES, June 21, 2004

9 interests in the partnership as long as it actually reduces the current income of affected partners without commensurately increasing their entitlements upon liquidation. A revenue ruling based on the tax avoidance standard found in prior law 76 lends some support to the argument. In the ruling, partners in a brokerage and investment banking business had stated percentages in overall income but they could be paid only to the extent of profits in their own branches. The ruling concluded that assuming the principal purpose of the limitation was not tax avoidance, each partner s entire share of partnership income arose from local sources. 77 The obvious question, however, is whether the principal purpose of the limitation could be something other than tax avoidance when local-source income is virtually certain to be sufficient each year or even over the course of several years. Applying current law as interpreted in the Treasury regulations, the question is whether the limitation really affects a partner s interest in the partnership when it is quite likely not to apply. The example in the regulations dealing with offsetting adjustments in later years suggests that it does not. The example indicates that a special allocation would not be treated as in accordance with the partners interests in the partnership if there were a strong likelihood that offsetting distributions would reverse it Until 1976, section 704(b) provided that [a] partner s distributive share of any item of income, gain, loss, deduction, or credit shall be determined in accordance with his distributive share of taxable income or loss of the partnership, as described in section 702(a)(9), for the taxable year, if (1) the partnership agreement does not provide as to the partner s distributive share of such item, or (2) the principal purpose of any provision in the partnership agreement with respect to the partner s distributive share of such item is the avoidance or evasion of any tax imposed by this subtitle. Section 704(b), amended by P.L (1976). 77 Rev. Rul , C.B. 188 (Situation 2); see LTR A (income allocation by source for section 911 purposes respected when shortfalls to be made up out of future income from same source). 78 See Treas. reg. section (b)(3)(i), (b)(3)(ii) (flush language referencing Example 8), (b)(5), Example 8(ii). See also Treas. reg. section (b)(3)(ii) (flush language referencing Example 5), (b)(5), Example 5, (b)(5), Example 10; supra text accompanying notes 62 and The tax authorities take the position that a payment based on gross receipts can be a guaranteed payment when unrelated parties performing similar services are paid on that basis. Rev. Rul , C.B At least one court has disagreed. See Pratt v. Comm r, 64 T.C. 203 (1975), aff d in part and rev d in part 550 F.2d 1023 (5th Cir. 1977). COMMENTARY / SPECIAL REPORT B. Guaranteed Payments A multinational partnership may be able to limit the income that a partner receives from foreign sources by giving the partner a guaranteed payment for services performed in the capacity of a partner. A guaranteed payment is an amount to which the partner is entitled without regard to the income of the partnership. 79 The partnership might call it salary. Statute provides that a guaranteed payment is treated like a payment to a nonpartner, but only for purposes of the statute governing the partner s inclusions in gross income and the statute governing the partnership s deductions. 80 For all other purposes, according to the Treasury regulations, a guaranteed payment is treated like a distributive share of partnership income. 81 Amounts formally designated as guaranteed payments are not distributive shares even though the partnership is virtually certain to have profits more than sufficient to pay them. 82 If a partner with a percentage interest in partnership income is guaranteed a minimum payment, however, the minimum amount is not a guaranteed payment to the extent the partner s percentage interest in income covers it. 83 Those rather arcane distinctions are unfamiliar outside the United States, and their obscurity also has lead to uncertainty within the United States. 84 Partnerships must use guaranteed payments cautiously for both reasons. From a U.S. point of view, guaranteed payments might be useful to a unitary partnership in at least four situations. First, if the source of a guaranteed payment for services is the place where the partner performs the services, guaranteed payments to non-u.s. partners working outside the United States could reduce or eliminate their U.S. tax exposure. Non-U.S. partners would not be subject to U.S. tax on their non-u.s. source earned income. 85 Second, given the same assumption about source, guaranteed payments to expatriate U.S. partners could increase their foreign-source income. The increase could ensure expatriate partners enough foreign-source income to benefit fully from a statute 86 that allows expatriates to exclude a specified amount of foreignsource earned income from their gross incomes. It also could allow expatriate partners exposed to high foreign tax on U.S.-source partnership income to enjoy a greater U.S. foreign tax credit limitation. 87 Third, when foreign 80 Section 707(c) (referencing sections 61 and 162). The legislative history of the provision for guaranteed payments suggests it was enacted so that partners receiving payments for services in amounts greater than partnership income would not be considered to have received either a tax-free return of his own capital or a taxable payment from the capital of other partners. See Kampel v. Comm r, 634 F.2d 708, 713 (2d Cir. 1980); Miller, 52 T.C. at ; S. Rep. No at 92 (1954). 81 Treas. reg. section (c); see sections 706(a) (guaranteed payments included in partner s income based on partnership items for the partnership tax year ended within the partner s tax year), 1402(a)(13) (limited partner s self-employment income does not include distributive share other than guaranteed payments). 82 Miller, 52 T.C. at Treas. reg. section (c), Example Commentators and legislators have proposed abolishing the peculiar concept of a guaranteed payment because there is no justification for distinguishing such payments from similar payments made to partners in their nonpartner capacity or similar distributions made to partners in their partner capacity. See, e.g., Joint Comm. on Taxation, Review of Selected Entity Classification and Partnership Tax Issues, JCS-6-97 at (Apr. 8, 1997). 85 See sections 864(c)(4), 871(a), and (b). 86 Section Partner would not have this problem if it could benefit from a treaty resourcing provision. See supra note 20. TAX NOTES, June 21,

10 COMMENTARY / SPECIAL REPORT countries treat guaranteed payments as salary or other income arising where the partner works, guaranteed payments to U.S. partners working in the United States could reduce or eliminate their non-u.s. tax exposure. U.S. partners would not be subject to non-u.s. tax on the guaranteed payments. Fourth, if the partnership s deduction of a guaranteed payment for services is attributable to the branch where the services were performed, guaranteed payments to partners working in the United States could reduce the amount of income from U.S. operations allocable to non-u.s. partners. Guaranteed payments to partners working outside the United States also could reduce the amount of foreign-source income allocable to U.S. partners. Although that would reduce the U.S. partners foreign tax credit limitations, the U.S. partners nevertheless could benefit in situations in which the payments reduced foreign taxes because the foreign country treated them as deductible salaries. It is not clear, however, how confident a partnership can be about strategies other than the first one. Courts have held that the source of a guaranteed payment for services is the place where the services were performed, but their analysis may not apply for foreign tax credit purposes. The decided cases involved guaranteed payments to expatriate U.S. partners in U.S.-based partnerships whose distributive shares of partnership income did not give them enough foreign-source income to benefit fully from the foreign-source earned income exclusion. In that context, the courts concluded that the statutory direction to treat guaranteed payments as payments to a nonpartner for purposes of determining the amount to include in the partner s income supported characterizing the payments as compensation for purposes of determining the amount to exclude. 88 The question in computing a foreign tax credit limitation, by contrast, is how to source income concededly recognized. The statutory provision that a guaranteed payment should be treated as a distributive share for all purposes other than determining inclusion in income therefore may apply. Guaranteed payments sometimes are treated as distributive shares of partnership income for other purposes, 89 suggesting that the statute could be interpreted literally. 88 Carey v. United States, 427 F.2d 763 (Ct. Cl. 1970); Miller, 52 T.C The rationale of the cases seems to undercut the statement in Treas. reg. section 1.707(c) that, because a guaranteed payment must be treated as a distributive share for purposes of all provisions other than section 61, a partner receiving a guaranteed payment while he is absent from work due to illness or injury may not exclude the payment from gross income under now repealed section 105(d). See Armstrong v. Phinney, 394 F.2d 661, 664 n.10 (5th Cir. 1968) (partner receiving guaranteed payment might be eligible to exclude from income under section 119 the value of employer-provided meals and lodging); GCM (July 25, 1969) (discussing Armstrong). 89 See Rev. Rul , C.B. 184 (fringe benefits); Rev. Rul , C.B. 459 (self-employment tax). But see Armstrong, 394 F.2d at 664 n.10 (meals and lodging exclusion); but cf. Treas. reg. sections (h)(1) (for foreign tax credit separate limitation purposes, look-through rules apply to guaranteed payments equivalent to interest, rents or royalties paid to 10 percent partners), (a)-1(a)(2) and (b) (distinguishing (Footnote 89 continued in next column.) Treating guaranteed payments as expenses attributable to the income earned by the partners receiving them would affect the proportion of a partnership s net income arising from U.S. and foreign sources. 90 The narrow rationale of the cases on the income side does not necessarily support treating the payments as expenses for purposes other than allowing the partnership a deduction. But support for treating guaranteed payments as allocable expenses can be found in cases considering how much partnership income could be taxed at the reduced rate once applied to earned income. Those cases hold that because the statute treats guaranteed payments as deductible payments to nonpartners, they must be deducted in determining a partnership s net profits. 91 That approach seems sensible. If guaranteed payments are sourced like compensation on the income side, failure to treat them as allocable expenses would produce anomalies. Unless guaranteed payments to U.S. partners are treated as expenses of the U.S. operations, the total amount taxed in the hands of the U.S. partners and the non-u.s. partners would exceed the net profits of the U.S. operations. In the same way, failing to treat guaranteed payments to non-u.s. partners as expenses of the foreign operations would overstate the partnership s overall foreign-source income. Even if guaranteed payments were sourced like compensation, they may be no better than overt allocations based on source. Overt allocations could be effective if they actually affect partners relative interests in partnership income and capital and there are insufficient prospects of future compensating adjustments. 92 Guaranteed payments offer nothing more unless payments that track distributive share and guaranteed payments in providing both subject to self-employment tax). The current withholding regulations might be read to say that whether guaranteed payments are subject to withholding tax depends on whether the underlying partnership income from which they come is withholdable. See Treas. reg. section (b)(2)(i)(A) (providing in the paragraph on the withholding obligations of transparent U.S. payees that U.S. partnership shall withhold when any distributions that include amounts subject to withholding (including guaranteed payments made by a U.S. partnership) are made ). In private letter rulings and internal memoranda, the IRS has taken the position that guaranteed payments for the use of capital are treated like distributive shares of underlying income for certain purposes. LTR (Apr. 13, 1987) (guaranteed payments to a real estate investment trust treated as share of partnership s rental income); LTR (Dec. 24, 1986) (same); LTR (June 27, 1986) (same); GCM (June 25, 1969) (guaranteed payments treated as share of partnership s royalty income eligible for percentage depletion). 90 See generally Treas. reg. sections (a), (a)(2) and (b), T(c)(1), (b). 91 Ledbetter v. United States, 792 F.2d 1015 (11th Cir. 1986) (regulation aggregating guaranteed payments with other partnership income to determine the amount of earned income that is invalid because it s inconsistent with section 707(c)); Zahler v. Comm r, 684 F.2d 356 (6th Cir. 1982) (similar). Contra, Kampel, 634 F.2d 708 (guaranteed payments aggregated with other partnership income to determine amount of earned income). 92 See supra text accompanying notes TAX NOTES, June 21, 2004

11 or shadow partnership distributions more exactly nevertheless could be treated as guaranteed payments. There is a basis for such formalism. The courts have found that amounts denominated as guaranteed payments will be so treated for purposes of the foreign earned income exclusion even if the partner s distributive share certainly would have exceeded the amount guaranteed. 93 The Treasury regulations take a similarly formal, although somewhat more confused, approach. 94 Given basic substance over form principles, however, a partnership might hesitate before relying on the form of guaranteed payments that regularly adjusted from year to year to compensate for over- or underpayments in previous years. C. Tax-Adjusted Distributive Shares A partnership could adjust partners distributive shares to mitigate the tax disadvantages of its multinational operations. When some partners pay less tax than they would have paid if they had received only residence-country income and other partners pay more than they would have paid, the partnership could reduce the distributive shares of partners who pay less and increase the distributive shares of partners who pay more. When the partners collective tax burden is greater than it would have been, the partnership might take the further step of equalizing the incremental tax by reducing the distributive shares of partners with effective tax rates below the overall average and increasing the distributive shares of partners with effective tax rates above the average. The tax consequences of multinational operations for particular partners will differ for many reasons, but differences arising from national systems for avoiding double taxation of foreign-source income are one cause that can serve to illustrate how tax-adjusted distributive shares might work. Many countries, such as Germany and the Netherlands, relieve double taxation on business profits by exempting foreign income from tax under local law or under treaties. 95 Partners in those countries benefit from the exclusion to the extent the source-country tax on their foreign-source income is less than the residence country tax would have been. 96 They suffer, of course, when the source-country tax burden is greater or when foreign operations produce losses, which are not deductible in the residence country under an exemption system. Other countries, such as the United Kingdom and the United States, relieve double taxation with foreign tax credits. Partners in those countries cannot benefit when the source-country tax on their foreign-source income is 93 See supra note Compare Treas. reg. section (c), Example 1 with id., Example See, e.g., Income Tax Treaty, Neth.-U.S., Dec. 18, 1992, art. 25(2); Income Tax Treaty, Ger.-U.S., Aug. 29, 1989, art. 23(2); see also Andersen, U.S. Income Tax Treaties, par [3]. 96 A benefit remains even if the residence country uses exemption with progression, which takes the exempted foreignsource income into account to determine the marginal rate at which the resident taxpayer must pay tax on his or her taxable income. COMMENTARY / SPECIAL REPORT less than the residence-country tax because the residence country taxes all of their income. They suffer to the extent the source-country tax is greater because they generally cannot claim credit for the excess tax. 97 They also suffer when other limitations prevent them from claiming credit even for foreign tax paid at rates equivalent to the residence country rate. 98 Thus, in general, all partners in a multinational partnership suffer to the extent sourcecountry tax is greater than residence-country tax, but only partners in exemption countries benefit to the extent source-country tax is less than residence-country tax. 99 Tax-based adjustments to distributive shares would depend on how multinational operations have affected the partners. The simplest adjustments should be those reallocating a windfall benefit like that enjoyed by partners in exemption countries who pay less tax to the extent they receive more foreign-source income. The partnership can divert the windfall to relieve partners in credit countries who pay more tax when they receive more foreign-source income. Adjustments that equalize overall additional tax may be more difficult because they might leave some partners paying more tax than they would have paid if they received all of their income from domestic sources. If the partners overall suffer incremental net tax because they receive foreign-source income, however, the partnership could treat the incremental tax as though it were an expense of the partnership by increasing the partnership shares of the partners whose effective tax burdens are heavier than the partnership average and decreasing the partnership shares of partners whose effective tax burdens are lighter than the average. As a practical matter, both windfall and equalization adjustments probably would be based on some standard assumptions about the tax attributes of partners in particular jurisdictions rather than on the more particular information typically used to equalize the tax burden of expatriate employees. Allocations of income or loss made to adjust profits shares on an after-tax basis would be respected for U.S. federal income tax purposes if they have substantial economic effect. 100 The allocations actually change the 97 A U.S. partner, for example, can use excess foreign tax credits from partnership income only if he or she has other foreign-source income in the same limitation categories that has not borne foreign tax at the partner s effective rate of U.S. rate. See section 904(d). 98 See supra part I.B In general, the gross economic detriment to any partner as a percentage of his or her partnership income is: percent partnership income from countries taxing at an effective rate higher than the residence tax rate times (effective percent source-country tax rate minus effective percent residencecountry tax rate). The gross economic benefit to a partner in an exemption country as a percentage of his or her partnership income is: percent partnership income exempted times (effective percent residence-country tax rate minus effective percent source-country tax rates). 100 A partnership might adjust distributive shares by allocating items of income, gain, deduction, or loss, but it is much more likely simply to allocate net taxable income or loss (a so-called bottom line allocation). All of those allocations are subject to the same tests, although a net income or loss allocation is less likely (Footnote 100 continued on next page.) TAX NOTES, June 21,

12 COMMENTARY / SPECIAL REPORT partners relative entitlements to partnership income, so they generally would have economic effect within the meaning of the relevant Treasury regulations. 101 The economic effect also should be substantial within the meaning of the regulations. The regulations provide that an allocation has substantial effect if it substantially affects the amounts that partners receive from the partnership. The effect is not substantial, however, if it increases the present value of any partner s after-tax return without creating a strong likelihood that the present value of another partner s after-tax return will be substantially diminished. 102 Tax-adjustment allocations would affect the amounts that partners receive from the partnership independent of tax consequences. The partnership presumably would not make the allocations unless the partners perceived the effects to be material, so resulting differences in the amounts partners receive should be substantial enough to satisfy the regulations. The allocations would aim to reduce or eliminate differences in the after-tax positions of partners resident in different countries, but they should not increase any partner s income after U.S. tax without reducing some other partner s income after U.S. tax. Any allocation benefiting U.S. partners should reduce non-u.s. partners pretax share in partnership income. Assuming income is not allocated by source, the smaller pretax share would translate into commensurately less income after paying U.S. tax. 103 to appear tax motivated. See Treas. reg. section (b)(1)(vii). The partnership cannot allocate tax credits for tax imposed on the partners because the credits belong to the partners who bear the tax. Cf. id. section (b)(4)(ii) (allocations of tax credits lack economic effect except to the extent the credits arise from properly allocated expenses). 101 See Treas. reg. section (b)(2)(ii). 102 Treas. reg. section (b)(2)(iii)(a) (the so-called dollar amount and overall present value tests). The effect also is not substantial if there is a strong likelihood, which in this situation there generally would not be, that other allocations will offset it. Treas. reg. section (b)(2)(iii)(b) and (c) (shifting and transitory allocations). 103 While the regulations do not specify that only U.S. tax consequences are relevant in determining whether allocations have substantial effect, that seems sufficiently clear from the absence of any indication to the contrary. In recent informal advice to its auditors on issues involving partnership allocations between U.S. and non-u.s. partners, the IRS National Office has taken only U.S. federal income tax into account in determining whether allocations had substantial effect. See, e.g., FSA , Doc , 2001 TNT (early-year losses specially allocated to U.S. partner); FSA , Doc , 2001 TNT (same); FSA , Doc , 2001 TNT (lease stripping shifted income to non-u.s. partners). Applying the test by reference to worldwide tax consequences would require qualifying a foreign assessment as a tax, quantifying the tax burden, and dealing with other issues encountered in foreign tax credit determinations, all issues to which the regulations do not allude. See, e.g., United States v. Goodyear Tire and Rubber Co., 493 U.S. 132 (1989) (calculating earnings and profits under U.S. tax principles to determine portion of earnings distributed to U.S. shareholder); Compaq Computer Corp. v. Comm r, 277 F.3d 778, Doc , 2002 TNT 1-5 (5th Cir. 2001) (determining whether transaction in which (Footnote 103 continued in next column.) Although theoretically workable, tax-based adjustments to distributive shares may not be a practical solution to the tax problems of a multinational partnership for at least two reasons. First, inefficiency remains when the partners collectively suffer incremental tax from multinational operations. Reallocation does not reduce the additional tax burden. Second, some partners may receive materially less after-tax income. When the partners overall incremental tax is large enough and when partners unequalized tax burdens are different enough, the reallocations required to equalize after-tax incomes could produce material reductions in the aftertax incomes of partners whose tax burden is below the average. The partners who enjoy it may resist even reallocations of a windfall benefit. Tax-adjustment allocations therefore are likely to be used only when any overall incremental tax is a relatively small percentage of partnership income and when the negative reallocations are either relatively small or relatively few. D. Reverse Hybrid Election A unitary multinational partnership might prefer to incorporate and then to pay its partners deductible salaries. Salaries received by partners working outside the United States should be non-u.s.-source income, and salaries received by partners working in the United States should be U.S.-source income. 104 The non-u.s. partners therefore would not need to pay U.S. tax on their income from the partnership. Assuming other source countries treated the payments as salaries, the U.S. partners also could avoid paying foreign tax. Deductions for partner compensation would be intended to offset substantially all of the income remaining after satisfying other expenses. The corporation would pay entity-level tax only to the extent of the return on the equity capital that it needed (or the tax authorities established that it needed) to conduct its business. Although theoretically workable, tax-based adjustments to distributive shares may not be a practical solution to the tax problems of a multinational partnership for at least two reasons. A partnership based in the United States is unlikely to adopt this approach as a practical matter. In partnership businesses in which capital is an important incomeproducing factor, the entity-level tax on the amount properly treated as a return on equity is a significant U.S. taxpayer incurred foreign tax had sufficient economic substance); Treas. reg. section When allocations equalize rather than optimize partners worldwide tax burden, taking non-u.s. taxes into account also could reduce U.S. tax. Here, for example, U.S. taxable income would be reduced by disregarding allocations of additional net income (including ratable amounts of foreign-source income) made to U.S. partners when the effective U.S. tax rate exceeds the partners average worldwide tax rate. 104 Sections 861(a)(3), 862(a)(3) TAX NOTES, June 21, 2004

13 deterrent. Even in businesses for which capital is not an important income-producing factor, the risk of entitylevel tax and the absence of offsetting advantages likely are dispositive. Deductions for salaries could substantially eliminate entity-level tax as long as the salaries can be defended as reasonable, and some professionals and professional organizations at one time did incorporate so they could use the more favorable pension schemes available to corporate employees under prior law. But the practice generally ceased after revised legislation gave partners access to equivalent pension schemes. 105 Even businesses seeking to limit the liability of their participants and investors no longer need to incorporate. The widespread acceptance of limited liability companies and the emergence of limited liability partnerships have allowed professionals as well as businessmen the benefit of limited liability without the risk or burden of entitylevel taxation. In recent years, therefore, businesses that do not need to issue publicly traded equity securities 106 generally have chosen to be treated as partnerships for tax purposes. Partnerships based outside the United States might evaluate the corporate alternative differently if capital is not an important income-producing factor and compensation to the U.S.-based partners at least equals the U.S. profits. Indeed, some service partnerships based outside the United States long ago adopted the roughly equivalent strategy of operating in the United States through a subsidiary corporation. Under current law, a partnership formed under non-u.s. law simply could elect to be treated as a corporation for U.S. tax purposes without changing its legal status or the non-u.s. tax treatment of its partners. 107 This reverse hybrid entity then could contract to pay its U.S.-based partners salaries. 108 The reverse hybrid would allocate the salaries paid to U.S.- based partners and other direct expenses against the 105 See Miller Mfg. v. Comm r, 149 F.2d 421 (4th Cir. 1945); Treas. reg. section (a); Boris Bittker and Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, paras and 62.2 (3d ed. 1999) (discussing the meaning of reasonable compensation and pension benefit under prior law that lead to incorporation); William McKee, et al., Federal Taxation of Partnerships and Partners, paras and 3.06 (3d ed (discussing the pension benefit under prior law that lead to incorporation). 106 See section Treas. reg. section (a). 108 The contractual arrangements would depend on the tax consequences in other relevant countries and other factors. For example, the U.S. partners might be given (i) a fixed salary that would be adjusted from year to year in order to approximate the partnership distributions received by comparable partners, (ii) a fixed salary plus a bonus based on profits, or (iii) a fixed salary and a partnership interest participating in profits above a threshold. See also supra Part II.B. COMMENTARY / SPECIAL REPORT income from its U.S. business. 109 It would aim to have little net income from the U.S. business after deducting salaries, other direct expenses, and apportionable worldwide expenses. It therefore would expect to pay little U.S. net income tax and to make no actual or constructive remittances to which U.S. branch profits tax could apply. It also would expect to treat salaries paid to the U.S. partners as deductible compensation for non-u.s. tax purposes. The arrangement therefore would shield non- U.S. partners from U.S. tax and U.S. partners from foreign tax. Individuals engaged in multinational businesses often seek to avoid the unattractive alternatives available to a unitary partnership by using multiple partnerships. The strategy becomes less attractive for an enterprise that expects to remit U.S. profits to foreign partners. The reverse hybrid entity would incur U.S. net income tax on the amount by which income effectively connected with its U.S. business exceeds the deductions for U.S. salaries. That alone might be acceptable where the effective U.S. tax rate is no greater than the non-u.s. partners effective domestic tax rate and the non-u.s. partners can claim foreign tax credits or exclude the foreign-source income. But the reverse hybrid entity also could incur U.S. branch profits tax. The branch profits tax applies at the 30 percent dividend withholding rate to reductions in the net equity of the U.S. branch. 110 Few U.S. treaties still prevent branch taxation, although U.S. treaties typically reduce the tax rate to the dividend withholding rate for corporate direct investors. 111 The reverse hybrid entity would not qualify for the rate reduction because, not 109 See Treas. reg. sections , T, The reverse hybrid might charge its non-u.s. offices arm s-length amounts for goods or services provided to them and pay them arm s-length amounts for goods or services received from them, but those intracorporate transactions generally would not be respected for U.S. tax purposes. See, e.g., Treas. reg. sections (c)(1)(i), (b)(1)(iv), (c)(2)(vii), (d)(2)(viii), (a)(10); Rev. Rul , C.B But see Nat l Westminster Bank v. United States, 44 Fed. Cl. 120, Doc , 99 TNT (1999), appeal denied 232 F.3d 906 (Fed. Cir. 2000), further proceedings 58 Fed. Cl. 491, Doc , 2003 TNT (2003). 110 Section A typical U.S. treaty permits the United States to impose branch profits tax on a company, which it defines as a body corporate or an entity that is treated as a body corporate for tax purposes under the law of the country where it is organized. The treaty then provides that the branch profits tax rate shall not exceed the withholding tax rate specified for dividends to direct corporate investors. See, e.g., 1996 U.S. Model Treaty, arts. 3(1)(b) and (2), 10(8) and (9); Income Tax Treaty, Aug. 29, 1989, Ger.-U.S., arts. 3(1)(e) and (2), 10(8) and (9); U.S. Treas. Dep t, Tech. Expl. of 1996 U.S. Model Income Tax Treaty, art. 3. TAX NOTES, June 21,

14 COMMENTARY / SPECIAL REPORT being liable to tax in its home country, it is not a resident within the meaning of the treaty. 112 If individual partners are entitled to treaty benefits, however, they may be able to claim the rate reduction under an interpretation of the treaty s branch profits tax provision or nondiscrimination article. 113 Whether the to-54.5-percent combined burden of the U.S. net income and branch profits tax would be acceptable to non-u.s. partners depends on the effective tax rate and the efficacy of double tax relief in their residence countries. 114 III. Multiple Partnership Alternatives Individuals engaged in multinational businesses often seek to avoid the unattractive alternatives available to a unitary partnership by using multiple partnerships. The basic U.S. federal income tax concern with multiple partnerships is that the partnerships will be treated as a single partnership or, which amounts to substantially the same thing, as themselves partners in a joint venture. If the partnerships are not a single partnership or joint venture, they confront at least two other important questions. One is whether charges between related entities are made on an arm s-length basis. The other is whether any income equalization allocations have substantial economic effect. Consider those questions in the cases of two simple multiple partnership prototypes. A. Parallel Partnerships The first prototype involves parallel partnerships, one conducting business in the United States and another conducting business elsewhere. 115 The U.S.-resident individuals are partners in both partnerships but they are entitled to payments from the non-u.s. partnership only 112 See section 884(e)(1) and (2); Income Tax Treaty, Aug. 29, 1989, Ger.-U.S., arts. 4(1); 1996 U.S. Model Treaty, arts. 4(1). 113 See, e.g., Treas. reg. section (d); Income Tax Treaty, July 24, 2001, U.K.-U.S., arts. 1(8) (income of transparent entities), 3(1)(c) ( enterprise ), (d) ( business ), and (e) ( enterprise of a Contracting State ), 4(1) ( resident ), 10(8) (rate not in excess of the rate specified for corporate direct investors), 25(2) (taxation on a permanent establishment of an enterprise not to be less favorable); Income Tax Treaty, Aug. 29, 1989, Ger.-U.S., arts. 3(1)(f) ( enterprise ), 4(1)(b) (resident receiving income of transparent entity), 10(9) (rate not exceeding the rate specified for corporate direct investors), 24(2) (taxation on a permanent establishment of an enterprise not to be less favorable); 1996 U.S. Model Treaty, arts. 3(1)(c) ( enterprise includes an enterprise carried on by a resident of a Contracting State through an entity that is treated as fiscally transparent in that Contracting State ), 4(1), 10(9), 24(2); U.S. Treas. Dep t, Tech. Expl. of 2001 U.K.-U.S. Treaty, art. 3 (c) (enterprise includes performance of professional and other independent services); U.S. Treas. Dep t, Tech. Expl. of 1996 U.S. Model Income Tax Treaty, art. 3 (enterprises conducted through fiscally transparent entities); OECD Comm. on Fiscal Affairs, Commentaries on the 2003 OECD Model Tax Convention, art. 3, par. 4 (Jan. 28, 2003) (enterprise includes performance of professional and other independent services). 114 The effective tax burden on remitted, after-tax income is: (100 x 35 percent corporate tax) + [100 x (1-35 percent) x percent branch profits tax]. The lowest branch profits tax rate, available under many treaties, is 5 percent. 115 In practice, of course, the enterprise may have more than one non-u.s. partnership. to the extent that the U.S. partnership s profits fail to fund distributions commensurate with those received by comparable partners in the non-u.s. partnership. The non-u.s. residents are partners only in the non-u.s. partnership. 116 The non-u.s. partnership has an interest in the U.S. partnership that entitles it to profits not distributable to the U.S. partners. The non-u.s. partnership s interest in the U.S. partnership does not give it control. Each partnership conducts separate partnership meetings and maintains a separate governance structure. To the extent practical, each partnership contracts with its own customers and suppliers, collects its own income, pays its own expenses, and controls its own funds. The costs of common services are shared on an arm s-length basis. When one partnership assists the other on a project, it treats the other partnership as its customer and charges it for goods or service on an arm s-length basis. The U.S. partnership expects the U.S. partners to receive substantially all of its profits, and the non-u.s. partnership expects the non-u.s. partners to receive substantially all of its profits. 1. Single partnership. The first question is whether the parallel partnerships are a single partnership for tax purposes. A tax partnership exists when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is a community of interest in the profits and losses, which entails a sharing in the profits or losses or both. 117 There need be neither a partnership under state law nor an express agreement. 118 The tax statutes define 116 If the non-u.s. partners were partners in the U.S. partnership, the risk that a share of their income would be treated as arising from the U.S. business would increase significantly for reasons intimated elsewhere in this article. 117 Comm r v. Culbertson, 337 U.S. 733, 740, 741 (1949) (quoting Comm r v. Tower, 327 U.S. 280, 286, 287 (1946)). Culbertson, which considered when individuals could be treated as partners in a family partnership, is generally regarded as setting the standard for determining whether an arrangement is a partnership for tax purposes. The first of the two passages quoted above concludes by referring to a community of interest in the profits and losses, but the second (in the language quoted above) expressly contemplates sharing in profits, losses, or both. Subsequent decisions make it clear that sharing in profits alone is sufficient to create a partnership. See, e.g., McDougal v. Comm r, 62 T.C. 720, 725 (1974); Wheeler v. Comm r, 37 T.C.M. (CCH) 883 (1978); Rev. Rul , C.B Treasury regulations and subsequent decisions, however, make it less likely that sharing in losses alone could be sufficient. See Treas. reg. section (a)(2) (cost sharing); Federal Bulk Carriers v. Comm r, 66 T.C. 283 (1976), aff d on other grounds 558 F.2d 128 (2d Cir. 1977); LTR A (April 28, 1975); cf. Treas. reg. section (cost sharing). But cf. Madison Gas and Elec. Co. v. Comm r, 72 T.C. 521, 561 (1979), aff d on other grounds 633 F.2d 512 (7th Cir. 1980) (joint undertaking not intended to produce a profit might constitute a partnership); Rev. Rul , C.B. 13 (same); LTR (Nov. 26, 1990) (business trust formed to clean up hazardous waste site classified as partnership despite absence of profit motive). 118 The definition of partnership under common law, the Uniform Partnership Act and the Revised Uniform Partnership Act, one of which forms the basis for the partnership statutes of all American states, is substantially similar to the federal income (Footnote 118 continued on next page.) 1522 TAX NOTES, June 21, 2004

15 partnership to include a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on. 119 A joint venture is any special combination of two or more persons, where in some specific venture a profit is jointly sought without any actual partnership or corporate designation. 120 Whether parties have formed a joint venture or any other type of partnership is a question of fact. 121 The factual inquiry is whether the parties really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both. 122 Their intention is determined from all of the facts, including (i) any oral or written agreements, (ii) the conduct of the parties in executing the agreements, (iii) the conduct of business in a joint name, (iv) the capital, goods, and service provided by the parties, (v) the control exercised by the parties over the conduct of the activity, and (vi) the participation of the parties as coproprietors in profit or loss from the activity. 123 Parallel partnerships could be treated as a single partnership if, despite formally separate agreements, their partners operate as members of a single enterprise. 124 The tax characterization depends on all of the facts and circumstances. Observation of separate legal formalities is an important, but not a dispositive, factor. The partnerships also need to attach proper formalities to their use of common communications and accounting systems and other support services. More significant is the way in which the two partnerships present themselves to the public. They should not hold themselves out tax definition in any event. See, e.g., Unif. Partnership Act section 6 (2003); Del. Code Ann. tit. 6, section (2004); N.Y. Partnership Law section 10 (Consol. 2004). State law typically requires a writing to establish limited liability for limited partners, but not to form a partnership. See, e.g., Del. Code Ann. tit. 6, section (2004)1; N.Y. Partnership Law section 91 (Consol. 2004). Under American law, a partnership typically is regarded as a separate juridical entity that can make contracts, sue, and be sued in its own name. See, e.g., Del. Code Ann. tit. 6, section (2004). 119 Sections 761(a), 7701(a)(2). 120 See Luna v. Comm r, 42 T.C. 1067, 1077 (1964); Allison v. Comm r, 35 T.C.M. (CCH) 1069 (1976). But cf. Brannen v. Comm r, 78 T.C. 471, 512 n.16, aff d 722 F.2d 695 (11th Cir. 1975) (tax shelter partnership that did not have a profit motive constituted a partnership). 121 Culbertson, 337 U.S. at ; Comm r v. Tower, 327 U.S. 280, (1946). 122 Culbertson, 337 U.S. at See Culbertson, 337 U.S. at 742, 747; Rev. Rul , C.B See Federal Bulk Carriers, 66 T.C. 283; Est. of Smith v. Comm r, 313 F.2d 724 (8th Cir. 1963); Burde v. Comm r, 43 T.C. 252 (1964), aff d 352 F.2d 995 (2d Cir. 1965) (co-owners of invention who jointly developed and marketed it were partners despite absence of partnership agreement); Luckey v. Comm r, 41T.C. 1 (1963), aff d 334 F.2d 719 (9th Cir. 1964) (individuals pooling funds to purchase and develop property were partners); Beck Chem. Equip. Corp. v. Comm r, 27 T.C. 840 (1957) (joint venture treated as partnership may be informal). COMMENTARY / SPECIAL REPORT as a single partnership. Separately incorporated entities can operate under similar names and use the same brand name without losing their separate status, 125 but separate partnerships doing those things need to exercise greater care. 126 Indeed, they could be treated as a single partnership even under state law if they hold themselves out as a single partnership. 127 At least one set of partners should not be able to participate in control of the other partnership because otherwise the partners together would control both partnerships. Despite formally separate governance, in other words, the same individuals would control the assets, activities, and income of both partnerships. Common control of the partnerships businesses would help support single partnership treatment. The most critical fact is the way in which the partners share profits and losses. A common profit pool is the hallmark of partnership. Arrangements through which the parallel partnerships attempt to equalize their partners profit shares therefore could be determinative. The decisive distinction in practice is likely to be between arrangements giving comparable partners in each partnership equivalent distributions and arrangements allowing the partners in each partnership access to the profits of the other to achieve that result. Profits seem to be pooled when the partnerships set distributions by reference to their combined profits and then fund them by shifting profits either to the U.S. partners through their access interests in the non-u.s. partnership or to the non-u.s. partners through the non-u.s. partnership s interest in the U.S. partnership. In contrast, an agreement to make equivalent distributions may not result in the sharing of profit and loss if there is no cross-ownership. Absent access interests for some partners or crossinterests for the partnerships, the partners in one partnership would have no proprietary interest in the profits of the other. The more profitable partnership presumably could distribute to its partners additional amounts sufficient to pay their taxes on its undistributed profits. The undistributed profits might be lent or, depending on which partnership had them, contributed to the other partnership. Indeed, as long as each partnership expects to have sufficient income to fund the equivalent distributions to its own partners, the partnerships agreement 125 See W. Braun Co. v. Comm r, 396 F.2d 264 (2d Cir. 1968); Comm r v. Chelsea Prods., 197 F.2d 620 (3d Cir. 1952) (three subsidiaries operating under same name as parent respected as separate entities). See generally Moline Properties v. Comm r, 131 F.2d 388 (5th Cir. 1942). 126 See G.R. Kinney Co. v. Comm r, 26 B.T.A. 1091, 1094 (1932) (48 stores conducting business under same name treated as separate partnerships because local partners participated in each store); Wagner v. Comm r, 17 T.C.M. (CCH) 569 (1958) (two partnerships with overlapping ownership conducting affiliated businesses respected as separate entities). 127 See, e.g., Unif. Partnership Act section 16(1) (partnership by estoppel); N.Y. Partnership Law section 27 (Consol. 2004) (same); cf. Cromer Fin. v. Berger, 137 F. Supp.2d 452, 488 (S.D.N.Y. 2001) (dismissing partnership by estoppel claim against Ernst and Young International); infra note 137. TAX NOTES, June 21,

16 COMMENTARY / SPECIAL REPORT to make equalizing payments, should one of them find itself unable to fund those distributions, might be treated as a type of cross-guarantee rather than a pooling of profits. 128 The partnerships arguably could be distinct for tax purposes even though they pool profits if the partners in each partnership have materially different exposures to losses and liabilities. The partners would seem to have equivalent exposures when there is cross-ownership and both partnerships are general partnerships. Even if the partnerships are separate for legal purposes, the U.S. partners would have unlimited liability for losses in the non-u.s. partnership to which they belong and the non-u.s. partners would have the same exposure to losses in the U.S. partnership to which their general partnership belongs. In other cases, however, materially different exposures may exist. When the non-u.s. partnership is the sole limited partner in the U.S. partnership, for example, the U.S. general partners obviously would have greater exposure to U.S. losses. When the U.S. partners are the only limited partners in the non-u.s. partnership, the non-u.s. partners would take a similarly greater exposure to non-u.s. losses. Loss exposures could differ materially even if all partners have limited liability. The differences could arise because one partnership has greater capital, undertakes riskier business ventures, or suffers greater exposure to tort liabilities. Arrangements between the partnerships for indemnification or sharing of the otherwise different risks could undercut the distinctions. In any event, the argument suffers from the observation that service partners who invest no capital and take no responsibility for covering losses typically are treated as partners for tax purposes in partnerships for which capital is not a material income-producing factor Joint venture. Even if the parallel partnerships were separate partnerships for tax purposes, they could be treated as partners in a single joint venture if they combine their efforts to produce and share a single pool 128 See Est. of Smith, 313 F.2d at (self-styled joint venture to share profits from trading accounts was not a partnership because only one party had a proprietary interest in the accounts); Federal Bulk Carrier, 66 T.C. at 293 (tanker seller that guaranteed projected base earnings and shared in excess earnings not in partnership with buyer); Rev. Rul 75-43, C.B. 383 (cattle owner not in partnership with cattle feeder who bore risk on 10 percent of feeding costs and shared in 10 percent of profit). 129 See, e.g., McDougal, 62 T.C. at 725 (service partner treated as partner); Wheeler, 37 T.C.M. (CCH) 883 (service partner in development partnership contributed only services and bore no losses until cumulative profit made); Halstead v. Comm r, 19 T.C.M. (CCH) 571 (1953) (partnership where only one lawyer required to cover expenses of firm); Bartholomew v. Comm r, 10 T.C.M. (CCH) 957 (1951), on remand from 186 F.2d 315 (8th Cir. 1951) (engineer contributing only services and no capital was partner); Rev. Rul , C.B. 284 (similar). See also Grubb v. Comm r, 60 T.C.M. (CCH) 458 (1990) (individual receiving only guaranteed payment was partner). But see Sugg v. Hopkins, 11 F.2d 517 (5th Cir. 1926) (service partner entitled to half of profits and losses was not partner because lacked proprietary interest in partnership property). of profits. In most cases, the cooperation between different arms of a multinational enterprise does not create a tax partnership. Affiliates within multinational corporate groups routinely cooperate extensively without being treated as partners in constructive partnerships. National tax authorities instead determine their shares of the multinational enterprise s profits by sourcing the enterprise s income and applying the arm s-length standard to related party dealings. 130 Cooperation and dealings between separate partnerships that trade under a common brand should be treated no differently. Cooperation between separate entities nevertheless can create a joint venture in some cases. Corporations have considered this issue in the context of virtual mergers in which two previously unrelated corporations contribute their subsidiaries to one or more commonly owned operating entities, but themselves remain separate corporations with distinct shareholders. To complete their combination, the corporations enter into governance and dividend equalization agreements. Besides committing them to pay equivalent dividends, an equalization agreement might commit them to make incomeequalizing payments to each other to make that possible. No traded U.S. corporation has entered into such a transaction because of concern that the equalization agreement and other arrangements would cause the two corporations to become engaged in a partnership for U.S. tax purposes. 131 The governance and profit equalization arrangements of parallel partnerships present similar concerns. If the partnerships hold themselves out as a single enterprise, cooperate closely to do their business, share common management, and equalize profits, they may be engaged in a joint venture. The income attributable to the joint venture would depend on the joint activities undertaken, but it likely would include at least each partnership s income from providing goods or services to customers of the other and from joint projects or trading. 132 The particular equalization arrangement 130 See, e.g., 2003 OECD Model Treaty, art. 9 (associated enterprises); Treas. reg. sections et seq. The much-vilified unitary method of apportionment used by a few U.S. states is the principal exception to this norm, and to a considerable extent it effectively does treat the affiliated companies as participants in a single enterprise sharing a single profit pool. 131 Partnership treatment generally would be undesirable because the partnership would be engaged in a U.S. trade or business to which its U.S.-source income and perhaps some of its foreign-source income would be attributed, thus exposing the non-u.s. participant to greater U.S. taxation. See generally David A. Waimon, Steven M. Surdell, and J. Russell Carr, Almost a Merger: Achieving Cross-Border Shareholder Unity Without a Shareholder Exchange, 78 Taxes 163, (2000). The exposure can be substantially reduced, at least in theory, if the participants drop all of their non-u.s. operations into a non-u.s. joint operating company so that they yield only foreign-source dividend income not effectively connected with the U.S. trade or business. There also are various techniques for actual partnership combinations. See Michael A. Humphreys, Partnership Combinations of U.S. Corporations and Non-U.S. Corporations, Tax Notes, July 9, 2001, p Cf. prop. Treas. reg. sections , (h), (c)(2)(iv), (c)(3)(ii), and (c)(5)(vi)(a), (b)(2)(ii)(d)(3), (Footnote 132 continued on next page.) 1524 TAX NOTES, June 21, 2004

17 employed access interests for some partners, crossinterests for the partnerships, or an equalization contract between the partnerships probably would not affect the conclusion. 3. Related-party transactions. If the parallel partnerships are separate partnerships not engaged in a joint venture, they must defend the transactions between themselves and their special allocations to equalize profits. To account for their transactions, they must decide how to share the costs of common services and how to charge for goods and services provided to each other. The tax consequences of those transactions should be determined under the arm s-length standard applicable to related party transactions. The standard would apply either because the partnerships have sufficient overlapping ownership or because they are acting in concert. 133 The practical difficulty of complying with the arm s-length standard may be considerable, but compliance should not present issues beyond those encountered by multinational corporate businesses. The issues presented by the parallel partnerships special allocations of income or expenses to equalize or redistribute partner profits are peculiar to partnerships, but they are essentially those considered in the discussion of unitary partnerships. As a basis for considering whether the allocations would be respected for U.S. tax purposes, assume the U.S. partners access interests in the non-u.s. partnership and the non-u.s. partnership s interest in the U.S. partnership operate as devices for funding supplemental distributions. In other words, the non-u.s. partnership allocates profits to the U.S. partners and the U.S. partnership allocates profits to the non-u.s. partnership only as necessary to equalize the distributive shares of the U.S. and non-u.s. partners. The special allocations should have economic effect within the meaning of the Treasury regulations. The persons receiving the allocations actually would receive additional income and related cash distribution. The economic effect may not be substantial, however, if there are arrangements for economically offsetting allocations in future years. The concern would arise if, for example, the non-u.s. partnership s special distributions to the U.S. partners in one year entitled it to receive an offsetting special distribution from the U.S. partnership in another year and the offsetting distribution was strongly likely to occur. The parallel partnerships special allocations nevertheless might be (b)(3)(i), and (b)(3)(ii)(c) (sourcing, allocating, and attributing income from global trading by affiliated entities). 133 See Cappuccilli v. Comm r, 668 F.2d 138 (2d Cir. 1981), aff g 40 T.C.M. (CCH) 1084 (1980); B. Forman Co. v. Comm r, 453 F.2d 1144 (2d Cir. 1972), rev g on this issue 54 T.C. 912 (1970), cert. denied 407 U.S. 934 (1972); Garbini Elec. v. Comm r, 43 T.C.M. (CCH) 919 (1982); Treas. reg. section (i)(4) (control includes control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose ); U.S. Treas. Dep t, Tech. Expl. of 2001 U.K.-U.S. Treaty, art. 9 (effective control standard equivalent to section 483); U.S. Treas. Dep t, Tech. Expl. of 1996 U.S. Model Income Tax Treaty, art. 9 (similar); FSA , Doc , 2002 TNT (parties to lease stripping acted in concert); FSA (May 21, 1999) (same); FSA , Doc , 1999 TNT respected if they are in accordance with the partners interests in the partnerships. Even that standard could be difficult to satisfy, however, when an offsetting distribution is strongly likely to be made in proximate years or when any offsetting distribution will be adjusted for time value. 134 B. Umbrella Structures COMMENTARY / SPECIAL REPORT The second multiple partnership prototype involves a U.S. partnership and a non-u.s. partnership trading under a common brand and transacting with each other under a so-called umbrella agreement. The U.S. resident individuals are the only partners in the U.S. partnership, and the non-u.s. individuals are the only partners in the non-u.s. partnership. The partnerships create an umbrella entity, which might be a partnership, a cooperative, or a company formed in a tax-efficient jurisdiction. The umbrella entity holds the brand name and other critical shared intangibles, and it licenses or sublicenses the separate partnerships to use them in distinct geographic or business areas. 135 If it does not hold the common intangibles, it has agreements with the separate partnerships to regulate their use of the intangibles and their business practices. The umbrella entity also provides common services to both partnerships for appropriate arm s-length charges. Among those services may be administration, finance, accounting, information technology, and common brand management. The umbrella entity also may intermediate transactions between the partnerships. If it does, a partnership seeking goods or services from the other partnership buys them from the umbrella entity, which buys them from the other partnership. The umbrella entity may earn a markup to compensate for handling the transaction. All of the interests in the umbrella entity belong to the two partnerships in proportions that may vary to reflect their relative contributions to the entity or the relative volumes of their transactions with it. The two partnerships therefore control the appointment of the umbrella entity s officers. 1. Single partnership. Partnerships in an umbrella structure are less likely than parallel partnerships to be treated as a single partnership for tax purposes. The two partnerships have no common partners and no common governance. Their umbrella agreement or their separate agreements with the umbrella entity may centralize the management of their brand and working practices. The agreements may even extend to global marketing and appointment of global leadership. But the umbrella entity 134 See supra text accompanying notes The umbrella entity will not have developed the brand or other intangibles in most situations, but the partnerships might contribute, sell or license global rights to the umbrella entity and then take back limited sublicenses. Those transactions would present a variety of U.S. federal income tax issues for the U.S. partnership and its partners, but the transactions might not be taxable when, for example, the umbrella entity is a partnership or a U.S. cooperative. See generally sections 351, 367(d), 721, (repealed). TAX NOTES, June 21,

18 COMMENTARY / SPECIAL REPORT is not itself engaged in the partnerships incomeproducing activities. In that respect, it resembles a corporate management company that provides executive management and headquarters functions for group companies. More importantly, the partners in the two partnerships do not share profits. The partners in neither partnership have a right to distributions from the other, and the partnerships have no income equalization agreement. Charges assessed by the umbrella entity may create opportunities for adjusting the relative profits of the two partnerships. For example, franchise fees might be greater percentages of higher profits and service fees might scale upward as a partnership s payroll, premises, or turnover increase. The umbrella entity also might negotiate discounted rates for purchasing high volumes of goods or services from one entity for deliver to the other. Although those charges and rates would need to survive scrutiny under the arm s-length standard, there probably is scope for using them to support the less profitable partnership without sharing profits. The partners also do not share losses. Since the two partnerships have no common partners and no interests in each other, the partners in one have neither direct nor indirect exposure to losses in the other. Indemnification arrangements for damages that one may cause to the other through misuse of the brand or other intangibles could effect a sharing of losses, but perhaps less easily when the umbrella entity holds or controls the intangibles and makes the arrangements. 2. Joint venture. For similar reasons, an umbrella structure is less likely to put the two partnerships into a joint venture as to their principal businesses. An unincorporated umbrella entity that simply handles common services should not be treated as a partnership because it is essentially a cost-sharing arrangement. 136 An unincorporated umbrella entity that intermediates between the partnerships and perhaps generates a profit to help support the less profitable partnership could constitute a partnership. But the umbrella partnership s business is different from the underlying businesses conducted by the two operating partnerships. An umbrella entity that takes the further step of providing common management certainly coordinates the efforts of the operating partnerships. But it probably does not cause their underlying businesses to be conducted in partnership for the same reason a group management company generally does not put members of its corporate group into partnership when it helps each member earn a separate profit. The joint business conducted through the umbrella entity is the provision of common services and management rather than the underlying, income-producing businesses 136 See Treas. reg. section (a)(2); LTR A (April 28, 1975) (umbrella structure was expense-sharing arrangement and not partnership). But cf. LTR (Nov. 26, 1990) (business trust formed to clean up hazardous waste site was partnership). themselves. 137 The umbrella arrangement should not be treated like the joint operating agreements for running power plants that have been held to constitute partnerships. Under a joint operating agreement, the parties operated a commonly owned plant to generate output. 138 Under the umbrella structure, by contrast, it is the separate operating partnerships themselves that produce the output. Incorporating the umbrella entity might mitigate concerns about its activities causing the separate partnerships to have a joint venture. The umbrella corporation should be treated as a separate entity earning a separate profit. 139 The tax on its profit could be light if it were formed and operated in a low-tax jurisdiction. If the corporation must do business in the United States, it perhaps could avoid entity-level tax by operating on a cooperative basis. The income of a cooperative allocated to its members is deducted by the cooperative and taxed in the hands of the members. The umbrella entity with only two members probably would not have the mutuality needed to qualify for cooperative status, but an entity serving a larger network perhaps could qualify Related-party transactions. If the separate partnerships in an umbrella structure are not in a joint venture, the transactions between them could be arranged to satisfy the arm s-length standard. Indeed, use of the umbrella entity may make it relatively easier to deal appropriately with common intangibles and common services. Even if the umbrella entity does not intermediate all transactions between the partnerships, it can help to ensure that the partnerships price and account for them properly. IV. Adaptive Choices Partnerships of individuals operating in multiple countries encounter tax inefficiencies. None of the remedies for those inefficiencies is entirely satisfactory. The appropriate choice for a particular partnership will depend on who belongs to it and how it does business. The basic alternatives considered here will not suit many partnerships, at least not without considerable refinement. Confronted by the difficulties of current law, each multinational partnership of individuals must cope in its own way. 137 In Cromer Fin. v. Berger, 137 F. Supp.2d at 488, the court dismissed a partnership by estoppel claim under New York law against Ernst and Young International and affiliated entities because the plaintiffs failed to establish that the entities had represented themselves as partners of Ernst and Young s Bermuda partnership. Allegations that the global professional services firm engaged in common marketing and advertising (and some affiliated entities operated under the same or similar names) were insufficient to support the partnership by estoppel claim. 138 See Madison Gas and Elec. Co. v. Comm r, 633 F.2d 512 (7th Cir. 1980), aff g 72 T.C. 521 (1979); Rev. Rul , C.B See supra note See generally Rev. Rul , C.B. 510 (marketing cooperative serving 10 members and 90 nonmembers), modified by Rev. Rul , C.B. 188; Rev. Rul , C.B. 170 (clearing research, advertising, and public relations organization serving members at cost) TAX NOTES, June 21, 2004