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All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland and the recipient. © 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP Federal Tax Partnership Developments: New Regulations and Recent Cases and Rulings Houston Tax Roundtable September 12, 2016

Federal Tax Partnership Developments: New Regulations and ......This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal

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Page 1: Federal Tax Partnership Developments: New Regulations and ......This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal

All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland and the recipient.

© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Federal Tax Partnership Developments: New Regulations and Recent Cases and Rulings

Houston Tax Roundtable September 12, 2016

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Navigating the New Partnership Audit Rules

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Basic Tax Treatment of Partnerships and Partners

The Conduit Approach of Subchapter K

- Under Subchapter K of the Code, an entity classified as a partnership is not subject to U.S. federal income tax

- Instead, the income, gain, loss, deduction and credit of the

partnership, as determined at the partnership level, passes through to the partners, and the partners annually report their shares of these items on their own income tax returns

- Consistent with this approach, federal income taxes arising from

adjustments to partnership tax items generally have been assessed against the partners of the partnership to whom the partnership tax items were allocated

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Current Law: TEFRA Procedures

Consistent Reporting Requirement - All partners must report their partnership items consistently with the treatment of such items by the

source partnership, unless they file a notice of inconsistent treatment (IRS Form 8082) Partnership Items Governed by Unified Partnership Proceedings

- The tax treatment of any “partnership item” and the applicability of any penalty, addition to tax or additional amount that relates to an adjustment to a partnership item is determined at the partnership level

Liability Arising from Partnership Item Adjustments Is Assessed at Partner Level

- Taxes, interest and penalties resulting from adjustments to partnership items are assessed at the partner level in the taxable year that was subject to review; e.g., assessments arising from adjustment to 2014 partnership items are made against the persons who were partners in 2014

Tax Matters Partner (TMP)

- Serves as the representative of the partnership in audits and judicial proceedings; acts as a liaison between the partnership and its partners and the IRS

Partner rights to notice, to participate in proceedings, and to independently seek a

judicial review of proposed adjustments

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Current Law: Role of TMP under TEFRA

Designation of TMP - The TMP must be a partner with authority under state law to act on behalf of the partnership (i.e., a

general partner of a partnership or a managing member of an LLC)

TMP Duties - Provide notice of beginning of audit and notice of final adjustments to “non-notice” partners - Provide other notices to all partners of certain information relating to audit and judicial proceedings The closing conference with the examining IRS agent; the proposed adjustments, rights of appeal and

requirements for filing a protest; the time and place of an appeals conference; the acceptance by the IRS of a settlement offer; any extensions to the statute of limitations; the filing of a request for administrative adjustment; the filing by any partner of a petition for judicial review; the filing of an appeal with respect to a judicial determination; and the final judicial re-determination

Authority of TMP - May extend statute of limitations with respect to partnership items for all partners - Sole authority to seek a judicial review or pursue a refund action on behalf of partnership (if TMP

files suit, that suit takes priority over suit filed by any other partner) - Authority to bind certain “non-notice” partners to settlement with the IRS - Once a proceeding is in Tax Court, the TMP may conclude a settlement for all partners if the TMP

stipulates that no partner objects to the settlement

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Current Law: Partner Rights under TEFRA

Notice - All partners entitled to notice of beginning of audit and notice of final adjustments (notice partners entitled to notice from

the IRS; non-notice partners entitled to notice from the TMP) - All partners entitled to information regarding administrative and judicial proceedings from the TMP (see prior slide)

Participation in Audit - All partners can participate in audit proceedings

IRS Appeals Review

- The TMP and notice partners are entitled to file protest with IRS Appeals and to request a conference with IRS Appeals (if multiple protests are filed, IRS Appeals will hold a consolidated conference)

Judicial Review

- The TMP can seek a judicial review of audit adjustments; notice partners entitled to seek a judicial review if theTMP chooses not to do so

- All partners with an interest in an outcome treated as a party to the proceeding

Settlement

- The TMP has certain settlement rights (see prior slide) - Any partner can enter into a settlement with the IRS; in general, if a partner enters into a settlement with the IRS, the

IRS must offer the same settlement terms to any other partner who requests them

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Current Law: Alternative Procedural Regimes

Small Partnerships (excepted from TEFRA, absent affirmative election) - A “small partnership” is a partnership that (i) has 10 or fewer partners AND (ii) each of which is a C

corporation, natural person or an estate of a deceased partner Small partnership exception does not apply if any partner is a “pass-thru partner”

- Separate audits and judicial proceedings conducted for each partner at the partner level - Taxes, interest and penalties resulting from proceedings assessed at the partner level in the

taxable year that was subject to review - Small partnership election into TEFRA can be revoked only with the consent of the IRS

Electing Large Partnerships (special elective regime for qualifying partnerships)

- Elective regime that applies to partnerships with at least 100 partners - Simplified flow-through of partnership items - Partners must file returns consistently - Partnership representative has sole authority - Adjustments taken into account in adjustment year - Election to pay tax at partnership level

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

The Bipartisan Budget Act of 2015 (Budget Act)

Signed by President Obama on November 2, 2015 For taxable years beginning after December 31, 2017

- TEFRA procedures (including TEFRA small partnership exception) and ELP regime are repealed - New Budget Act procedures take effect Partnerships may elect to apply Budget Act procedures for taxable years before January 1,

2018 Temp. Treas. Reg. § 301.9100-22T

Budget Act procedures are intended to simplify partnership audits and to facilitate

collection of taxes, interest and penalties attributable to audit adjustments Audits of partnerships are expected to increase JCT estimates that new procedures will raise approximately $9.3 billion over 10 years

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Partnerships Subject to Budget Act Procedures

General Rule - Budget Act procedures apply to any entity classified for federal income tax purposes as a

partnership that is required to file a federal income tax return

Opt-Out Election for Small Partnerships (qualifying electing partnerships excepted from

Budget Act procedures) - Requirements 100 or fewer Schedules K-1 for the taxable year Each partner for the taxable year is (i) an individual, (ii) a C corporation, (iii) a foreign entity

that would be treated as a C corporation if it were domestic, (iv) an S corporation, or (v) an estate of a deceased partner - Special look-through rule for S corps; requires disclosure of name and TIN of S corporation shareholders - Statute allows IRS to issue guidance to apply a look-through rule in the case of other types of entities

Election must be made annually on the partnership’s timely filed tax return for the applicable taxable year and must include the name and taxpayer identification number of each partner

Partnership must notify each partner of the election - If an Opt-Out Election is made, separate audits and judicial proceedings must be conducted for

each partner at the partner level

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: A Major Shift in Approach

Consistent Reporting Requirement - Failure to comply allows the IRS to assess without deficiency procedures at the partner level - Partner is excepted from the consistent reporting requirement if the partner files a notice of

inconsistent position - Any final decision with respect to an item excepted from the consistent reporting requirement in a

proceeding to which the partnership is not a partner is not binding on the partnership

Unified Partnership Level Proceedings - Adjustments to items of income, gain, loss, deduction or credit of a partnership for a partnership

taxable year (and any partner’s distributive share thereof) are determined in a single unified proceeding at the partnership level

Liability Imposed on the Partnership in the Adjustment Year

- Under the general rule, liability for taxes, interest and penalties is imposed on the partnership in the adjustment year (i.e., the year in which the adjustment becomes final following an audit or judicial proceeding) Economic cost of taxes, interest and penalties is effectively borne by the persons who are

partners in the year of the adjustment year, rather than the persons who were partners in the reviewed year

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: A Major Shift in Approach

Partnership Representative - Each partnership is required to designate a partner or other person with substantial presence in

the United States as the “partnership representative” - Designation made in a manner set forth in Treasury guidance - If no designation is made by the partnership, the IRS may select any person as the partnership

representative - Partnership representative has the sole authority to act on behalf of the partnership

Lack of Any Meaningful Partner Rights - The partnership and all partners are bound by actions taken by the partnership and by any final

decision in a partnership proceeding brought under the Budget Act rules - Examples: Settlement Agreement entered into by the partnership Notice of final partnership adjustment that is not contested Final decision of the court with respect to the partnership if the partnership contests the notice

of final partnership adjustment

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Commencement and Conclusion of Partnership Audit

The IRS is required to mail the following notices to the partnership and the partnership representative: - Notice of administrative proceeding - Notice of proposed adjustment resulting from such proceeding (NOPA) - Notice of final partnership adjustment (FPA)

FPA shall not be mailed earlier than 270 days after the NOPA is mailed Notices are sufficient if mailed to last known address of the partnership representative or

the partnership (even if the partnership has terminated its existence) If the partnership challenges the FPA in a judicial proceeding, the IRS is prohibited from

issuing another FPA for the taxable year, absent the showing of fraud, malfeasance or misrepresentation of material fact

The IRS may, with the consent of the partnership, rescind any notice of a partnership

adjustment

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Effect of Partnership Audit Adjustments

If a partnership adjustment results in an “imputed underpayment,” the partnership is required to pay the imputed underpayment as if it were a tax imposed on the partnership for the adjustment year

Any adjustment that does not result in an imputed underpayment is taken into

account by the partnership in the adjustment year: - As a reduction in non-separately stated income or an increase in non-

separately stated loss (whichever is appropriate), or - In the case of a credit, as a separately stated item

The effect of these rules is that the partnership may be liable for an imputed

underpayment for unfavorable partnership adjustments, but the partnership will not be entitled to a refund as a result of favorable adjustments

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Calculating Imputed Underpayment

General rule - All adjustments to partnership income, gain, loss or deduction for the reviewed year are

netted, and the resulting net amount is multiplied by the highest statutory tax rate applicable to individuals or corporations

- For purposes of this calculation: Any net increase or decrease in loss is treated as a decrease or increase,

respectively, in income; and Any adjustment to items of credit are taken into account as an adjustment to the

amount

Special rule for adjustments to distributive shares - Adjustments to the partners' allocable shares of items are not netted - Such adjustments are determined by disregarding (i) any decrease in a partner's share

of income or gain and (ii) any increase in a partner's share of loss or deduction

Accounting for character differences

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Calculating Imputed Underpayment – Example 1

Partnership AB reported net income from operations of $300,000 for its 2018 taxable year; the IRS audits Partnership AB's 2018 taxable year and determines that $100,000 of deductions claimed by Partnership AB should have been capitalized into the basis of land; the $100,000 adjustment becomes final in 2021; the highest marginal rate of tax in effect in 2021 for an individual or corporation is 39.6%

- The $100,000 adjustment results in a net increase in Partnership AB's income of

$100,000 - Imputed Underpayment = $100,000 net increase in income, multiplied by 39.6% =

$39,600 - Partnership AB is required to pay the $39,600 imputed underpayment as if it were an

additional tax in 2021

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Calculating Imputed Underpayment – Example 2

Partnership AB reported net loss from operations of $300,000 for its 2018 taxable year; the entire $300,000 loss was allocated to Partner B; the IRS audits Partnership AB's 2018 taxable year and determines that the loss should have been allocated equally between Partner A and Partner B; the highest marginal rate of tax in effect in 2021 for an individual or corporation is 39.6%

- For purposes of computing the imputed underpayment, the $150,000 increase in

Partner A's share of the loss is disregarded. The $150,000 decrease in Partner B's share of the loss is treated as a net increase in Partnership AB's income

- Imputed Underpayment = $150,000 net increase in income, multiplied by 39.6% =

$59,400 - The $59,400 is assessed and collected against the partnership as a tax imposed for

2021

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Calculating Imputed Underpayment – Example 3

Partnership AB reported net income from operations of $300,000 for its 2018 taxable year; the IRS audits Partnership AB's 2018 taxable year and determines that Partnership AB (1) omitted $10,000 of gross income and (2) incorrectly capitalized $30,000 of deductible costs; these adjustments become final in 2021; the highest marginal rate of tax in effect in 2021 for an individual or corporation is 39.6%

- The $10,000 of additional income and the $30,000 of additional deductions are netted,

resulting in a net adjustment of -$20,000 - There is no imputed underpayment - Partnership AB reports the -$20,000 adjustment in 2021 as a reduction in non-

separately stated income or an increase in non-separately stated loss (whichever is appropriate)

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Modification of Imputed Underpayment

Under Treasury guidance, an imputed underpayment may be modified on account of: - Partners for the reviewed year (i) filing amended returns to take into account all

adjustments and (ii) paying any taxes due - Partners that are not subject to tax (e.g., U.S. tax-exempt partners, foreign partners and

state governments) - C corporation partners - The amount of capital gain or qualified dividend income attributable to an individual or S

corporation partner (which for this purpose is treated as an individual) - Specified passive activity losses with respect to partners of a PTP - Other factors determined under Treasury guidance

Information must be submitted to the IRS no later than the close of the 270-day

period beginning on the date on which the NOPA is mailed, unless the period is extended with the consent of the IRS

Any modification requires the approval of the IRS

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Partnership Level Assessment, Collection and Payment

Any imputed underpayment arising from audit adjustments will be assessed and collected in the same manner as if it were a tax imposed on the partnership for the adjustment year

Partnership is liable for interest and any penalty, addition to tax or additional

amounts imposed on the imputed underpayment Payments are due no later than the due date of the partnership's tax return for

the adjustment year (determined without regard to extensions)

Partnership payments are not deductible

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Section 6226 Election Alternative

The partnership will not be liable for an imputed underpayment, if the partnership:

- Elects the application of IRC section 6226 not later than 45 days after the date of the

final notice of adjustment (a section 6226 election), AND - Furnishes an Adjusted K-1 (at the time and in the manner prescribed in Treasury

guidance) to each partner for the reviewed year and to the IRS showing the partner’s share of any adjustment to income, gain, loss, deduction or credit as determined in the FPA

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Section 6226 Election Alternative

Effect of Section 6226 election on partner tax liability - The tax liability of a partner for the taxable year, which includes the date of the Adjusted K-1, will be

increased by the sum of: The amount the partner’s tax in the reviewed year would increase as a result of the adjustment,

plus The amount that the partner’s tax liability would increase for all subsequent years as a result of

changes in tax attributes during such years

Interest is computed and imposed at the partner level - At the large corporate underpayment rate (i.e., the federal short-term rate plus 5% (rather than 3%))

Penalties determined at the partnership level and assessed against partners for the reviewed year

Section 6226 election will be made in the manner provided in Treasury guidance, and once

made, will be irrevocable without the IRS’s consent

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Budget Act: Administrative Adjustment Request (AAR)

A partnership may file an AAR in the amount of one or more items of income, gain, loss, deduction or credit of the partnership for any partnership taxable year

- Any adjustment is determined and taken into account for the taxable year in which the

administrative adjustment is made: By the partnership under rules similar to the imputed underpayment rules of section

6225 for the partnership taxable year in which the AAR is made; or By the partnership and partners under rules similar to the rules of section 6226

- If the AAR would NOT result in an imputed underpayment, only the section 6226 approach applies

Statute of limitations

- A partnership may not file an AAR more than three years after the later of (i) the date the partnership return is filed for the year or (ii) the last day for filing the return for the year (without regard to extensions)

- In no event can an AAR be filed after a NOPA for the partnership tax year is mailed

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Where Does This Leave Us Going Forward?

Client benefit/detriment; each deal is unique

How should rules be taken into account in new agreements? What disclosures should be included in offering documents? Should existing agreements be amended?

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Issues to Consider: Partnership Representative and Other Rights Regarding Taxes

Who has control over the appointment of the partnership representative? Who should be appointed? Failure to appoint? Death, resignation, dissolution? Rights of partners to notice, audit participation, consent, removal? Survival of partner rights following transfer of interest? Who bears the cost of conducting proceedings? Is the partnership

representative entitled to indemnity? Greater emphasis on allocation provisions, tax return preparation and review

rights, and accounting firm selection?

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Issues to Consider: Opt-Out Election for Small Partnerships

Is the partnership eligible? Qualifying partners? Could the partnership become eligible by restructuring? Transfer restrictions? Will lenders require the partnership to opt out? Do certain partners have an interest in keeping proceedings

at the partnership level?

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Issues to Consider: Effect of Partnership-Level Liability

Economic burden of imputed underpayment, interest and penalties may be borne by one or more partners of the partnership in the adjustment year

Partners and/or their ownership percentages may change between the reviewed year and

the adjustment year - E.g., FLIP partnership structures - Even if ownership does not change, one partner could bear the economic burden of another partner’s taxes based on

preferred returns in the distribution waterfall or required allocation of partnership-level expense

Require partners to take steps to reduce any imputed underpayment?

Equitably apportion any partnership liability among partners for the reviewed year?

- What factors should be considered? - Are tax detriments/benefits taken into account? - What is the effect of the partnership adjustments on tax basis and capital accounts?

Partner indemnity? Treat partner’s share of imputed underpayment as a withholding amount or tax distribution? - Survival; transfers of interests - Credit risk

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Issues to Consider: Section 6226 Election

Are partners permitted to file refund claims in connection with partner-favorable adjustments?

Application of election in tiered partnership structures?

- Is an upper-tier partnership permitted to push the adjustment out to its partners? - Is an upper-tier partnership permitted to file an AAR?

Do partners for the reviewed year have a right to force the partnership to seek a judicial review?

Will some partners desire to keep liability at the partnership level, even if the

partners must indemnify the partnership? Will lenders require?

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Issues to Consider: Purchasers of Partnership Interests and M&A Transactions

Tax reps and warranties? Tax diligence? Rights under partnership agreement? Indemnity and/or escrow arrangement? Accounting for tax benefits/detriments? Corresponding obligation of Purchaser to compensate Seller for favorable audit

adjustments taken into account by Purchaser in adjustment year (e.g., overstatement of income, or understatement of deductions)?

Structure around using newly formed subsidiary partnership?

What is the meaning of “ceases to exist”?

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

PLR 201608005

PARTNERSHIPS – TREATMENT OF CERTAIN LIABILITIES

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

PLR 201608005

Private Letter Ruling – Partnership Liabilities Core Principles

- A partner has an “outside” basis in his/her partnership interest, adjusted under section 705

- Section 722 provides that the outside basis acquired by a contribution of property, including money, shall be the amount of the money or the adjusted basis of the property at the time of the contribution

- Section 752(a) provides that any increase in a partner’s share of the liabilities of the partnership is considered as a contribution of money by the partner; accordingly, an increase in outside basis

- Section 731(a)(1) provides that gain is recognized by a partner in the event the partner receives a distribution of money that exceeds the partner’s outside basis

Treas. Reg. § 1.752-1(a)(4) defines a liability for purposes of section 752 as an obligation incurred that creates or increases the basis of any of the obligor’s assets (including cash); gives rise to an immediate deduction to the obligor; or gives rise to an expense that is not deductible in computing taxable income and not properly chargeable to capital

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Private Letter Ruling – Partnership Liabilities (cont.) Background Facts

- Partnership is engaged in the performance of a long-term construction contract and during the course of the contract receives milestone payments

- Does a distribution of the milestone payments to the partners potentially cause a

recognition of gain? - Does receipt of the milestone payment give rise to an obligation that is regarded as

a liability for purposes of section 752?

PLR 201608005

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Partnerships – United Airlines v. FERC (D.C. Cir. 07/01/16)

United Airlines v. FERC (D.C. Cir. 7/1/2016)

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP This communication cannot be used for the purpose of avoiding any penalties that may be imposed under federal, state or local tax law.

Oil pipeline organized as limited partnership Potentially impacts all pass-through entities subject to FERC

jurisdiction (e.g., transmission partnerships, REITs) Issue is Lakehead doctrine – inclusion of downstream (owner)

taxes in rates charged by pass-through entities Court sidestepped 2007 decision in Exxon v. FERC by concluding

that it allowed for challenges to the reasonableness of the tax inclusion

Court concluded that ROE already adequately compensated for tax risk so as factual matter there was double counting by inclusion of owner taxes

Remand to re-justify or eliminate double counting Petition filed to institute generic rulemaking proceeding to revisit

the 2005 Policy Statement on Income Tax Allowances

Partnerships – United Airlines v. FERC (D.C. Cir. 07/01/16)

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© 2016 SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP

Questions?

William E. Sheumaker

Sutherland Asbill & Brennan LLP 404.853.8023

[email protected]

H. Karl Zeswitz, Jr. Sutherland Asbill & Brennan LLP

202.383.0518 [email protected]

Bradley M. Seltzer Sutherland Asbill & Brennan LLP

202.383.0808 [email protected]

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State Tax Considerations of Partnerships and Other Pass-Through Entities

Houston Tax Roundtable September 12, 2016

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Agenda

General partnership principles (LLCs too)

State conformity to federal treatment of pass-through entities

State jurisdiction (nexus) to tax pass-through entities

Mechanisms for reaching income of nonresident partners/owners

Apportionment of pass-through entity income

New federal partnership audit rules

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General Partnership Principles (LLCs too)

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General Partnership Principles (LLCs too)

Single level of taxation (at the owner/member level) Pass-through treatment

- Character of income (e.g., capital gain, ordinary income) flows through to the owners/members

- Losses of partnership/LLC flow through to the owners/members

Ability to allocate tax items among partners (subject to limitations – e.g., passive income, at-risk rules)

Key Features of Federal Taxation of Partnerships and LLCs

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State Conformity to Federal Treatment of Pass-Through Entities

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State Conformity to Federal Treatment of Pass-Through Entities

State adoption of CTB regulations - Intended to simplify tax compliance and administration - 25 or so states conformed in 1997; almost all comply now … but

there are exceptions (discussed later)

State conformity is not as straight forward as it seems States have conformed in a variety of ways:

- Conformity statutes - Bulletins

States have varied in addressing the application of the CTB classification for all entities (some only address for certain entities, i.e., LLCs)

Check-the-Box (CTB) Application to State Income Taxes

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State Conformity to Federal Treatment of Pass-Through Entities

CTB regulations formulated for federal income tax purposes Some states apply CTB to non-income taxes Varying treatment of CTB for sales and use tax purposes

- See Virginia Public Document 98-157 for retail sales and use tax purposes; a DRE is considered a separate legal entity subject to the applicable Virginia sales and use tax laws

- See Ala. Code § 10A-5-1.06(b) (repealed eff. 1-1-2017) (following CTB treatment of LLCs for all state tax purposes except for the business privilege/corporate shares tax)

CTB Application to Other State Taxes

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State Jurisdiction to Tax Flow-Through Entities

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Can a state tax a nonresident partner or member? Before a state can tax a nonresident owner of a pass-

through entity that is doing business within its borders, it must be determined whether the state has jurisdiction over the nonresident States have varying statutory standards for determining

whether a nonresident partner or member has nexus - Colorado – 1 CCR 201-2: 39-22-301.1(2)(b), (c)(v) - Kentucky – Ky. Rev. Stat. § 141.010(25)(e), (26)

Statutory standards are subject to U.S. Constitutional limitations

Jurisdiction (Nexus) Overview

State Jurisdiction to Tax Flow-Through Entities

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States are limited in their ability to tax or impose a tax collection obligation on an out-of-state person or entity Due Process Clause Nexus

- The Due Process Clause prohibits a state from taxing a corporation unless there is some minimal connection or nexus with the state A finding that a corporation is “doing business” in a state is rarely

attributed to its shareholders

Commerce Clause Nexus

Constitutional Nexus

State Jurisdiction to Tax Flow-Through Entities

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States generally assert that a partner in a partnership having property or personnel in the state has nexus based on its ownership interest in the partnership Must determine whether the resident partner has

sufficient contacts with a state - Is the partner’s activity sufficient to be considered to be doing

business in the state? - Does the nonresident partner have sufficient contacts with the state

to satisfy the U.S. Constitutional nexus standards?

Nonresident Partner Nexus

State Jurisdiction to Tax Flow-Through Entities

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Aggregate Theory vs. Entity Theory Aggregate Theory

- Activities of the partnership attributed to the partners - Partners considered to be conducting the business of the

partnership - Based on common law treatment of partnership

Entity Theory - Partnership treated as an entity, distinct from partners - Partnership interest treated like an ownership interest in a

corporation - Revised Uniform Partnership Act (RUPA) treats partnership as

entity, distinct from its owners

Nonresident Partner Nexus

State Jurisdiction to Tax Flow-Through Entities

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State administrative decisions and case law generally have provided for flow through of nexus from partnership to corporate partners - North Carolina Secretary of Revenue Decision No. 97-548 (April

24, 1998) - Borden Chemicals and Plastics, L.P. v. Zehnder, 726 N.E.2d 73 (Ill.

App. Ct. 2000) - Georgia Reg. § 560-7-7-.03 - Massachusetts Reg. 830 CMR 63.39.1(8)(a)

But see, - In re Appeals of Amman & Schmid Finanz AG (Cal. SBE) (April 11,

1996)

Nonresident Partner Nexus

State Jurisdiction to Tax Flow-Through Entities

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Recent developments - Taxpayer victories: Corrigan v. Testa, Slip Op. No. 2016-Ohio-2805 (Ohio May 4, 2016) UTELCOM, Inc. and UCOM, Inc. v. Bridges (La. 2012) (cert. denied) BIS LP, Inc. v. Div. of Taxation (N.J. Tax Ct. 2009) Lanzi v. Ala. Dep’t of Revenue (Ala. Civ. App. 2006)

- Taxpayer losses: Sahi USA, Inc. v. Comm’r of Revenue (Mass. App. Tax Bd. 2006) DiBelardino v. Dep’t of Taxation (Va. Cir. Ct. 2007) In re: Shell Gas Gathering Corp. #2 (N.Y. Tax App. Trib. 2010) Village Super Market of PA, Inc. v. Director, Div. of Taxation (N.J.

Tax Ct. 2013)

Nonresident Partner Nexus

State Jurisdiction to Tax Flow-Through Entities

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Mechanisms for Reaching Income of Nonresident Partners/Owners

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Mechanisms for Reaching Income of Nonresident Partners/Owners

Most states (like federal) do not tax disregarded entities, partnerships, LLCs or S corporations However, there are exceptions…e.g.,

- Alabama – Net worth-based Business Privilege Tax

- California – LLC “tax” and LLC “fee”

- Illinois – Personal Property Replacement Income Tax

- Texas – Margin Tax – applies to “limited liability entities”

State Entity-Level Taxes

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Mechanisms for Reaching Income of Nonresident Partners/Owners

36 states impose withholding at the source on pass-through entities and nonresident owners - Generally triggered when a pass-through entity either:

Fails to file a composite return including nonresident owners

Fails to maintain or submit nonresident owner’s written consent to state taxing jurisdiction and agrees to pay tax on that owner’s distributive share of the pass-through entity’s income

Nonresident Withholding

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Mechanisms for Reaching Income of Nonresident Partners/Owners

If a state requires withholding, the pass-through entity generally pays tax at the highest individual or corporate tax rate multiplied by that owner’s distributive share of income attributable to the state - Some states require withholding only in connection with the state’s

allocable share of a distribution to a nonresident owner

- Some states except corporate partners from withholding

E.g., Idaho, Nebraska, Missouri (not clear how to include on the composite return, which only applies to personal income tax rates)

Nonresident Withholding

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Mechanisms for Reaching Income of Nonresident Partners/Owners

Four main types of state nonresident withholding provisions: - Composite return/nonresident consent to taxation

- Nonresident withholding required

- Estimated tax payments required

- Pass-through entity remains contingently liable

Some states require withholding if federal withholding required (e.g., if IRC §1441 withholding, then state withholding)

Treaties don’t apply at sub-national (state) level

Nonresident Withholding

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Apportionment of Pass-Through Entity Income

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Apportionment of Pass-Through Entity Income

PTE

Corp. Partner Indiv.

Is the pass-through entity unitary with the

corp. partner?

Is the individual a resident?

Is the entity or individual a general partner or a limited

partner?

Do the factors flow up?

Is the income the result of the sale of an

interest in a pass-through entity?

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Apportionment of Pass-Through Entity Income

Corporate partners - Is business/non-business income determination made at: The partnership level? The partner level?

- Most states have not addressed this issue Illinois has provided direct guidance on this issue – requiring the

determination of business/non-business income be done at the partnership level - Ill. Admin. Code tit. 86, §§ 100.3500 (a)(3), 100.3500(b)(1) (“Trade or

business activities of a partner or of any related party are irrelevant”)

Business/Non-Business Income

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Apportionment of Pass-Through Entity Income

Partner-level approach - Partners combine their share of the pass-through entity’s

apportionment factors with their own apportionment factors Referred to as “flow-through” or “flow-up” apportionment Also known as “partner-level” apportionment

- Example: Assume that a corporate partner has a 40% interest in a

partnership The corporate partner would calculate its own apportionment

factor by including 40% of the partnership’s sales, property, and payroll (assuming that the state uses a three-factor apportionment formula), but usually only if the partner and the partnership are unitary

Allocation and Apportionment

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Apportionment of Pass-Through Entity Income

Partnership-level approach - The pass-through entity’s income is apportioned to the state using

only the pass-through entity’s own apportionment factors - Owners of the pass-through entity then allocate their distributive

share of post-apportionment income to the appropriate state - Example: Assume that a corporate partner has a 40% interest in a

partnership, which earns $100 of income If apportionment is calculated at the partnership level, and the

partnership computes a 50% apportionment factor in a state, then the partner would include $20 of the partnership income in its tax base in that state

$100 x 40% = $40, and $40 x 50% = $20

Allocation and Apportionment

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Apportionment of Pass-Through Entity Income

Complexity – See California: - If partners are unitary with partnership, then partnership’s factors

“flow through” to the partners - If partners are not unitary with the partnership, then the factors do

not “flow through” to the partners - If partners and partnership are not unitary, but the income is

considered business income, then partners must apportion partnership income separately from their other business income

- Cal. Code Regs. tit. 18, §25137-1

Allocation and Apportionment

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Apportionment of Pass-Through Entity Income

Resident individuals generally are subject to tax on their entire distributive share of partnership income in their state of residence - Exception – Alabama (resident individuals can be taxed only on

their share of Alabama-source partnership income)

Nonresident individuals generally are subject to tax only on their share of partnership income earned within the state

Individual Partners

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Apportionment of Pass-Through Entity Income

What is the character of the interest being sold? - Partnership The sale of a partnership interest is generally treated as a sale of

an intangible, and the gain is apportioned based on the usual rules for sales of intangibles

- DRE When a DRE is being sold, it is likely that the state will treat

sellers as if they held the assets of the DRE directly (i.e., it is like selling a division of the corporate owner)

States have not provided must guidance on this issue

Sale of an Interest

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Apportionment of Pass-Through Entity Income

Is it business income? - Transaction Test If not in the business of buying and selling partnership interests,

there is a strong argument that the sale of the interest generates nonbusiness income and that the gain should be sourced to its commercial domicile

- Functional Test If the interest were an operational asset used in the business, its

sale would likely be held to generate business income

Sale of an Interest

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State Taxation and the New Federal Partnership Audit Rules

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State Taxation and the New Federal Partnership Audit Rules

Will state law conform to the new federal changes? - Not automatically

New federal rules are primarily in IRC §§ 6221 to 6241 (administrative procedures)

States use the IRC only to compute taxable income and do not incorporate IRC administrative procedures - States usually have their own procedures

Practitioners need guidance for dealing with partnership and operating agreements

State Issues

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State Taxation and the New Federal Partnership Audit Rules

Without automatic adoption, where does that leave states? - For partnerships assessed by the IRS at the entity level, how will

states impose related state tax?

- How are states to deal with the liability being assessed in the “year of adjustment” rather than the “year of review”?

- Most states never conformed to TEFRA

State Issues

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State Taxation and the New Federal Partnership Audit Rules

Many states already use two types of enforcement mechanisms for nonresident partners: - Impose withholding requirement on partnership for income passed

through to nonresident partners (or nonresident partner consents to state taxation)

- Impose a composite filing requirement

Could states modify/expand these to require entity level audit liability remittance?

Existing State Enforcement Mechanisms

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Questions?

Michele Borens Sutherland Asbill & Brennan LLP

202.383.0936 [email protected]

Todd Betor Sutherland Asbill & Brennan LLP

202.383.0855 [email protected]

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Connect with us!

Apple App Store Google Play Windows Phone Store Amazon Appstore

Download the Sutherland SALT Shaker app today:

@Sutherland_SALT Sutherland SALT Group

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All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland and the recipient.

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Case Study: Implications of Proposed Section 385 Regulations on Partnership Investments

Houston Tax Roundtable September 12, 2016

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Background

Deduction of related party interest expense currently limited under section 163(j)

– Current rule has been criticized as ineffective – Administration has proposed tightening rules – Legislation to tighten 163(j) has not been successful

Proposed section 385 regulations respond to calls to curb benefits of inversion transactions through existing law

– Reach is much broader than inversion transactions – Addresses transactions that have been targeted by

Administration budget proposals “Corporate Integration” proposal being discussed in Congress would

go the opposite route, conforming equity and debt treatment by giving a dividends paid deduction, but imposing a withholding tax on dividends

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Background

States have utilized other mechanisms to limit use of leverage and bar certain intercompany transactions

– Disallowing or limiting deductions for certain expenses payable to related parties

• Addback of otherwise deductible interest and intangible expenses paid or accrued to related parties

– Using IRC § 482 or analogous adjustment authority – Reporting on a unitary combined or water's edge combined

basis • No single unitary business test. Tests include the: (1) three unities test

(ownership, operation and use); (2) flow of value; and (3) contribution or dependency.

– Requiring pass-through entities to withhold tax when distributing current or prior year income to nonresident shareholders or partners

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Overview

On April 4, proposed regulations were issued under IRC § 385 (the Proposed Regulations) to address concerns associated with related-party debt

– IRC § 385, initially enacted in 1969, provides broad authority for regulations to determine whether an interest in a corporation is debt or equity for U.S. tax purposes

– Although issued as part of an “inversion” package, the Proposed Regulations apply to all corporate taxpayers, not just taxpayers that have engaged in inversion transactions

The Proposed Regulations would treat certain related-party debt, in

whole or in part, as equity for U.S. tax purposes – Generally apply to debt among members of an expanded corporate

group, which includes certain controlled partnerships – Consolidated group members are treated as a single taxpayer for

purposes of applying the rules

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Overview

The common law multi-factor debt-equity analysis still applies, but under the Proposed Regulations instruments treated as debt under the common law analysis will nonetheless be treated as equity for U.S. tax purposes if:

– Certain documentation requirements are not satisfied; or – If the debt is “per se equity” that is issued in connection with certain

transactions, generally distributions, stock sales and asset reorganizations

Although generally proposed to be effective when finalized, the per

se equity rules would apply to debt issued on or after April 4 that is still outstanding 90 days after the date the regulations are finalized

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Documentation Requirements

The Proposed Regulations introduce documentation and information retention requirements that must be satisfied in order for debt issued to a related party to be respected as debt for U.S. tax purposes

– Related-party debt that does not satisfy these requirements is treated as equity for U.S. tax purposes

The documentation must:

– Be contemporaneous (i.e., prepared within 30 days of the debt issuance); and

– Demonstrate the existence of what Treasury and the IRS describe as the essential characteristics of debt

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Documentation Requirements

The essential characteristics of debt that must be demonstrated through documentation are:

– Legally binding obligation to pay; – Creditor’s rights to enforce the obligation; – Reasonable expectation of payment at the time of creation,

demonstrated by cash flow projections, financial statements, business forecasts, asset appraisals and other relevant financial ratios (compared to industry averages); and

– An ongoing relationship during the life of the instrument consistent with arm’s-length relationships

Satisfaction of these documentation requirements does not

itself establish that an instrument will be respected as debt–the existing common law multi-factor debt-equity analysis must still be satisfied

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Certain related-party debt instruments issued in connection with certain transactions would be treated as equity for U.S. tax purposes under the Proposed Regulations

– Per se equity treatment applies even if the common law debt-equity factors and documentation requirements are otherwise satisfied

Per se equity treatment applies generally to debt instruments:

– Distributed (as a dividend or return of capital) by a company to a related shareholder;

– Issued in exchange for stock of an affiliate (including “hook stock” issued by a related shareholder); and

– Issued by an acquiring company as consideration in an internal asset reorganization (i.e., a reorganization within the meaning of IRC §§ 368(a)(1)(A), (C), (D), (F), or (G))

Per Se Equity

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A “funding rule” also would treat related-party debt that is issued with a principal purpose of funding one of the above transactions (i.e., a distribution of cash or other property, an acquisition of stock of an affiliate or an internal asset reorganization) as equity for U.S. tax purposes

– Non-rebuttable presumption that related-party debt issued within 36 months before or after one of the above transactions is treated as equity for U.S. tax purposes

– The Proposed Regulations include very limited exceptions from these rules

The per se equity rules are proposed to apply to debt instruments

issued on or after April 4 that are still outstanding 90 days after the regulations are finalized

Per Se Equity

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Consolidated Group Exception

The Proposed Regulations do not apply to debt instruments between members of a consolidated group, although the existing common law multi-factor debt-equity analysis continues to apply to these transactions

– To achieve this result, a consolidated group of corporations is treated as one corporation

– Transactions between different consolidated groups, or between a consolidated group member and a related foreign affiliate, could have unanticipated results

How, or even if, the consolidated group rule will be adopted and applied for

state tax purposes is an open question

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Consequences of Equity Characterization

Related-party debt that is treated as equity under the Proposed Regulations would be treated as equity for all U.S. tax purposes, including for example, sections 302, 304 and 305

– Under the preamble to the Proposed Regulations, determination of whether equity is common or preferred depends on the terms of the instrument

Equity characterization is expected to have consequences for the initial transaction, and for future transactions (e.g., repayment or exchange of instruments)

– Generally results in loss of interest expense deductions – Payments generally treated as dividends, potentially subject to different

withholding tax treatment – Could impact CFC treatment and cause U.S. entities to cease to be members

of consolidated group – No foreign tax credits on dividends or subpart F inclusions attributable to the

recharacterized instrument if treated as non-voting equity and holder does not also hold sufficient voting equity

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What the Proposed Regulations Mean Now?

• The Proposed Regulations are not currently effective, but they can implicate existing debt transactions. Companies should:

– Determine who is “related” for purposes of the Proposed Regulations

– Review intercompany debt policies and update as necessary to ensure compliance with documentation requirements

– With respect to per se equity transactions, review current intercompany financing structure and planning transactions for potential implications under the Proposed Regulations

– Consider application of the Proposed Regulations in performing diligence for acquisition targets and in structuring acquisition financing

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Application to Partnerships

To prevent the avoidance of these rules through the use of partnerships, the Proposed Regulations take an aggregate approach to controlled partnerships

– A partnership is treated as a controlled partnership if 80% or more of the interests in the capital or profits of the partnership are owned, directly or indirectly, by one or more members of an expanded group

– A member of an expanded group that is a partner in a controlled partnership is treated as owning its proportionate share of the controlled partnership’s assets

– Further, each expanded group partner in a controlled partnership is treated as issuing its proportionate share of any debt instrument issued by the controlled partnership

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Example 1

USS1

USS3

X Corp

USS2

USP

USPS

U.S. Federal Tax Considerations: Each of USP, USS1, USS2, USS3 and X Corp are

domestic corporations. USPS is a domestic partnership.

While X Corp is not a member of the USP Group, it is treated as a member of an expanded group that includes USP, USS1, USS2, USS3 and X Corp

For purposes of the Proposed Regulations, X Corp is treated as issuing proportionate shares of Note X to USS3 and USS2.

Under the Proposed Regulations, Note X (which is issued in a distribution) is treated as per se equity.

For all other federal tax purposes, Note X is treated as stock of X Corp that was distributed by X Corp to USPS in a distribution subject to section 305.

Based on Treas. Reg. § 1.385-3(g)(3), Example 13

Note X

50% 50%

X Corp distributes a note (Note X) to USPS

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Example 1

USS1

USS3

X Corp

USS2

USP

USPS

U.S. State and Local Tax Considerations: A state may conform to IRC § 385 and the Proposed

Regulations through using federal taxable income as its starting point.

Date of conformity may vary state by state. — Some states conform to the IRC as of a specific

date or have rolling conformity, which automatically updates to the version of the IRC in effect.

— Many states do not conform to the Treasury regulations in the same explicit manner as they do for the IRC.

If a state does not conform to the Proposed Regulations, Note X may be treated as debt for state tax purposes, while treated as per se equity under the Proposed Regulations. USS2 and USS3’s interest income from Note X may be subject to withholding for state tax purposes.

If a state that imposes a net-worth-based franchise tax conformed to Note X’s treatment as per se equity under the Proposed Regulations, the reclassification may carry over from income for franchise tax purposes.

Note X

50% 50%

X Corp distributes a note (Note X) to USPS

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Example 2

USS1

USS3

X Corp

USS2

USP

USPS

U.S. Federal Tax Considerations: In addition to the facts described in Example 1,

neither USS2 nor USS3 has any current year E&P. For purposes of the Proposed Regulations, USS2

and USS3 are each treated as issuing $100 of Note USPS to USP.

Under the Proposed Regulations, USS3’s portion of Note USPS is treated as equity under the “funding rule” because Note USPS is issued to USP, a member of the same expanded group, during the 72-month period in which the distributions by USS3 occurred. The distribution by USS2 is disregarded

because it is within the consolidated group. USS3 is treated as issuing $100 of stock to USP

and then contributing the proceeds to USPS.

Based on Treas. Reg. § 1.385-3(g)(3), Example 14

50% 50%

On Year 1, Date A, USP loans $200 to USPS (Note USPS results). On Year 1, Date B, USS2 distributes $100 to USP and USS3 distributes $100 to USS1.

Note USPS

$100 distribution

$100 distribution

Y Corp

25%

75%

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Example 2

USS1

USS3

X Corp

USS2

USP

USPS

50% 50%

On Year 1, Date A, USP loans $200 to USPS (Note USPS results). On Year 1, Date B, USS2 distributes $100 to USP and USS3 distributes $100 to USS1.

Resulting U.S. federal tax structure U.S. Federal Tax Considerations: Interest payments in respect of USS3’s portion of

the USPS Note would be deemed distributed by USPS to USS3 and then deemed distributed, potentially as dividends, by USS3 to USP.

The equity deemed issued by USS3 to USP could potentially cause USS3 to become a member of a U.S. consolidated group with USS1.

Y Corp

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Example 2

On Year 1, Date A, USP loans $200 to USPS (Note USPS results). On Year 1, Date B, USS2 distributes $100 to USP and USS3 distributes $100 to USS1.

U.S. State and Local Tax Considerations: If a combined reporting state does not conform to

the Proposed Regulations and USP, USS1, USS2 and USS3 are members of a combined group:

— Different state tax structure exists from the federal tax structure.

— USS2 and USS3’s shares of USPS’s interest expense would offset USP’s interest income from Note USPS.

— USS2’s $100 distribution to USP and USS3’s $100 distribution to USS1 are potentially dividends.

— If USS2’s $100 distribution to USP and USS3’s $100 distribution to USS1 are greater than its current state E&P, then the basis in USS2 and USS3 for state tax purposes would be less than the basis for federal tax purposes.

USS1

USS3

X Corp

USS2

USP

USPS

50% 50%

Note USPS

$100 distribution

$100 distribution

Y Corp

25%

75%

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Example 2

On Year 1, Date A, USP loans $200 to USPS (Note USPS results). On Year 1, Date B, USS2 distributes $100 to USP and USS3 distributes $100 to USS1.

U.S. State and Local Tax Considerations: If a separate reporting state does not conform to the Proposed

Regulations: — For example, New Jersey requires a corporation to adhere

to a federal pro forma return, subject to New Jersey’s adjustments – none of which relate to the Proposed Regulations. New Jersey potentially could not apply the Proposed Regulations. See General Bldg. Products Corp. v. State, Div. of Taxation, 14 N.J. Tax 232 (N.J. Tax Ct. 1994); MCI Commc’n Servs., Inc. v. Dir., Div. of Taxation (N.J. Tax Ct. 2015).

— USP receives interest income from Note USPS. — USS2 and USS3’s shares of USPS’s interest expense may

qualify for interest expense deductions (or subject to related-party interest expense addback).

— USS2’s $100 distribution to USP and USS3’s $100 distribution to USS1 are potentially dividends eligible for a dividend-received deduction for USP and USS1.

— If USS2’s $100 distribution to USP and USS3’s $100 distribution to USS1 are greater than its current state E&P, then the basis in USS2 and USS3 for state tax purposes would be less than the basis for federal tax purposes.

USS1

USS3

X Corp

USS2

USP

USPS

50% 50%

Note USPS

$100 distribution

$100 distribution

Y Corp

25%

75%

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Example 2

On Year 1, Date A, USP loans $200 to USPS (Note USPS results). On Year 1, Date B, USS2 distributes $100 to USP and USS3 distributes $100 to USS1.

Resulting U.S. federal tax structure U.S. State and Local Tax Considerations: If a state conforms to the Proposed Regulations and

USP, USS1, USS2 and USS3 are members of a combined group for state tax purposes:

— Potentially different federal tax and state tax reporting groups. For federal purposes, the equity deemed issued by USS3 could break consolidation such that USS3 would no longer be a member of a U.S. consolidated group with USS1, if USP were a non-U.S. entity. For state purposes, the equity deemed issued by USS3 may not break the unitary business or combined reporting requirements. Loss in USS3 and USS2’s interest deduction

from Note USPS for federal tax purposes would presumably increase federal taxable income.

If a separate reporting state does conform to the Proposed Regulations, USS3 and USS2 potentially would not get interest expense deductions (or be subject to related-party interest expense addbacks) from Note USPS.

USS1

USS3

X Corp

USS2

USP

USPS

50% 50%

Y Corp

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Questions?

Robert S. Chase

Sutherland Asbill & Brennan LLP 202.383.0194

[email protected]

Jeffrey A. Friedman Sutherland Asbill & Brennan LLP

202.383.0718 [email protected]

Taylor M. Kiessig

Sutherland Asbill & Brennan LLP 202.383.0844

[email protected]