SECTION 3. REASONS FOR

EXERCISING REGULATORY AUTHORITY

The Treasury Department and the IRS are aware that certain taxpayers purport to be able to contribute, consistently with sections 704(b), 704(c), and 482, property to a partnership that allocates the income or gain from the contributed property to related foreign partners that are not subject to U.S. tax. Many of these taxpayers choose a section 704(c) method other than the remedial method and/or use valuation techniques that are inconsistent with the arm’s length standard.

In 1997 Congress recognized that taxpayers might use a partnership to shift gain to a foreign person and consequently enacted sections 721(c) and 367(d)(3). Based on the experience of the IRS with the taxpayer positions described above, the Treasury Department and the IRS have determined that it is appropriate to exercise the regulatory authority granted in section 721(c) to override the application of section 721(a) to gain realized on the transfer of property to a partnership

(domestic or foreign) in certain circumstances in which the gain, when recognized, ultimately would be includible in the gross income of a foreign person. Although Congress also provided specific authority in section 367(d)(3) to address transfers of intangibles to partnerships, the Treasury Department and the IRS have concluded that acting pursuant to section 721(c) is more appropriate because the transactions at issue are not limited to transfers of intangible property.

Although section 704(b) provides partnerships a measure of flexibility to make special allocations of partnership income, the Treasury Department and the IRS believe that in some cases partnership transactions involving special allocations lead to inappropriate results. The Treasury Department and the IRS also are aware that certain taxpayers may be valuing property contributed to partnerships, or the property or services involved in related controlled transactions, in a manner contrary to section 482. As a result, partnership interests or consideration received in related controlled transactions also may be incorrectly valued, thereby reducing the amount of income or gain allocated to U.S. partners. For example, a partnership agreement might provide a domestic partner with a fixed preferred interest in exchange for the contribution of an intangible that is assigned a value that is inappropriately low, while specially allocating a greater share of the income from the intangible to a related foreign partner. Even though the IRS has broad authority under section 482 to make allocations to properly reflect the economics of a controlled transaction, administrative challenges arise, for example, when the IRS must make adjustments years after a transaction occurred. Because taxpayers have better access to information about their businesses and risk profiles, the IRS may be at a disadvantage in evaluating the transactions. Therefore, along with providing rules under section 721(c), the Treasury Department and the IRS intend to augment the section 482 rules as they apply to controlled transactions involving partnerships.

The Treasury Department and the IRS believe that remedial allocations can have the effect, in part, of ensuring that precontribution gain from contributed prop

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erty is properly taken into account by the contributing partner. Further, allocating all section 704(b) book items ( e.g., gain, income, loss, and deduction) associated with the contributed property in a consistent manner with respect to the contributing partner and any related foreign partner can help to ensure that the built-in gain associated with contributed property is properly taken into account by the contributing partner and that income is not inappropriately separated from related deductions. Accordingly, the Treasury Department and the IRS have determined that it is appropriate to allow for the continued application of section 721(a) to transfers to partnerships with related foreign partners only when the conditions described in section 4.03 of this notice are satisfied.