SECTION 5. RULES REGARDING

CONTROLLED TRANSACTIONS INVOLVING PARTNERSHIPS

.01 Regulations to Be Issued Regarding Controlled Transactions Involving Partnerships

The Treasury Department and the IRS intend to issue regulations regarding the application to controlled transactions involving partnerships of certain rules in § 1.482–7 that are currently applicable to cost sharing arrangements. In particular, the Treasury Department and the IRS intend to issue regulations that provide specified methods for such controlled transactions based on the specified methods in § 1.482–7(g) as appropriately adjusted in light of the differences in the facts and circumstances between such partnerships and cost sharing arrangements. Additionally, the regulations will provide periodic adjustment rules that are based on the principles of § 1.482–7(i)(6) for controlled transactions involving partnerships. The regulations will provide

with respect to all items related to the Section 721(c) Property contributed to the Section 721(c) Partnership through the close of the eighth full taxable year following the taxable year of the contribution. The regulations will not require the extension of the period of limitations for taxable years that end before the date of publication of the regulations.

.07 Examples

The following examples illustrate the rules described in section 4 of this notice. For simplicity of presentation, assume that there are no other controlled transactions that are related to the transactions described in the examples. See section 5 of this notice.

Example 1 . (i) Facts. USP, a domestic corporation, wholly owns FS, a foreign corporation. USP and FS form a new partnership, PRS. FS contributes cash of $1.5 million to PRS, and USP contributes the following three assets: a patent with an arm’s length price of $1.2 million and an adjusted basis of zero; a security (within the meaning of section 475(c)(2)) with an arm’s length price of $100,000 and an adjusted basis of $20,000; and a machine with an arm’s length price of $200,000 and an adjusted basis of $600,000.

(ii) Analysis. Because the patent has Built-in Gain, it is Section 721(c) Property. Although the security also has Built-in Gain, it is Excluded Property because it is an asset described in section 475(c)(2). The machine has a built-in loss and is therefore not Section 721(c) Property. Thus, because USP is a U.S. person and not a domestic partnership, USP is a U.S. Transferor that has contributed Section 721(c) Property. FS is related to USP under section 267(b) and is not a U.S. person. Accordingly, FS is a Related Foreign Person to USP. USP and FS collectively own more than 50% of the interests in the capital, profits, deductions, and losses of PRS. Therefore, PRS is a Section 721(c) Partnership. The de minimis rule described in section 4.02 of this notice does not apply because the sum of the Built-In Gain for all Section 721(c) Property is $1.2 million, which exceeds the $1 million de minimis threshold. The built-in loss in the machine does not factor into determining whether the contribution is below the de minimis threshold. As a result, under section 4.02 of this notice, section 721(a) does not apply to USP’s contribution of the patent to PRS, unless the Gain Deferral Method is applied.

Example 2 . (i) Facts . In Year 1, USP, a U.S. Transferor, contributes Section 721(c) Property (Asset 1) with Built-in Gain of more than $1 million to a Section 721(c) Partnership in which FS, a Related Foreign Person, is also a partner. The partnership allocates all items of income, gain, deduction, and loss with respect to Asset 1 60% to USP and 40% to FS and adopts the remedial allocation method with respect to Asset 1. The parties comply with the applicable reporting requirements under sections 6038, 6038B, and 6046A and the regulations there

under. The parties properly apply the Gain Deferral Method with respect to Asset 1 in Years 1 through 3.

In an unrelated transaction in Year 4, USP contributes Section 721(c) Property (Asset 2) with a Built-in Gain of $100,000 to the partnership. The partnership allocates all items of income, gain, and loss with respect to Asset 2 20% to USP and 80% to FS, but allocates deductions with respect to Asset 2 90% to USP and 10% to FS. The partnership adopts the remedial allocation method with respect to Asset 2.

(ii) Analysis. In Year 4, although Asset 2 has Built-in Gain of less than $1 million, the de minimis rule will not apply because the parties are applying the Gain Deferral Method with respect to Asset 1. Because the deductions with respect to Asset 2 are allocated in a different proportion than the other section 704(b) items with respect to Asset 2, the requirements for satisfying the Gain Deferral Method are not met with respect to Asset 2, and USP must recognize the Built-in Gain with respect to Asset 2. Furthermore, because the Gain Deferral Method does not apply to Asset 2, which was contributed within 60 months of Asset 1 (the Section 721(c) Property to which the Gain Deferral Method was first applied), an Acceleration Event is deemed to occur with respect to Asset 1 under section 4.05(1) of this notice, and USP must recognize any remaining Built-In Gain with respect to Asset 1.

Example 3. The facts are the same as in Example 2 except that USP does not contribute Asset 2. In Year 3, the partners amend the partnership agreement so that all items of income, gain, deduction, and loss with respect to Asset 1 are now allocated 30% to USP and 70% to FS. Assume the amendment is accompanied by any consideration required by section 482 and has substantial economic effect as required by section 704(b). Because each section 704(b) item with respect to Asset 1 continues to be allocated in the same proportion to each partner, the Gain Deferral Method will continue to apply so long as the other requirements of the Gain Deferral Method are satisfied.

Example 4. (i) Facts . In Year 1, USP, a U.S. Transferor, contributes Section 721(c) Property (Asset 1) with Built-in Gain of more than $1 million to a Section 721(c) Partnership (PRS) in which FS, a Related Foreign Person, and USX, an unrelated U.S. person, are also partners. The parties properly apply the Gain Deferral Method with respect to Asset 1. In Year 3, USP transfers all of its assets, including its interest in PRS, to USS, a domestic corporation, in a transaction to which section 381(a) applies. In Year 9 (a year in which there is remaining Built-In Gain with respect to Asset 1), PRS distributes Asset 1 to FS.

(ii) Analysis - Section 381(a) transfer to a do- mestic corporation. Although USP will no longer recognize any remaining Built-In Gain with respect to Asset 1 under the Gain Deferral Method following the transfer to USS, USS is a successor U.S. Transferor. Therefore, provided the requirements of the Gain Deferral Method continue to be satisfied, including treating USS as the U.S. Transferor, the transfer of USP’s interest in PRS to USS is not an Acceleration Event.

(iii) Analysis - Distribution of Section 721(c) Property. Although section 704(c)(1)(B) does not apply to the distribution, the distribution is an Ac

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that, in the event of a trigger based on a significant divergence of actual returns from projected returns for controlled transactions involving a partnership, the IRS may make periodic adjustments to the results of such transactions under a method based on § 1.482–7(i)(6)(v), as appropriately adjusted, as well as any necessary corresponding adjustments to section 704(b) or section 704(c) allocations.

The Treasury Department and the IRS also are considering issuing regulations under § 1.6662–6(d) to require additional documentation for certain controlled transactions involving partnerships. These regulations may require, for example, documentation of projected returns for property contributed to a partnership (as well as attributable to related controlled transactions) and of projected partnership allocations, including projected remedial allocations covered by section 4 of this notice, for a specified number of years.

.02 Application of Current Law to Transactions Described in this Notice

Under existing law, section 482 and related penalties apply to controlled transactions involving partnerships, including the transactions described in this notice. For example, where U.S. and foreign persons under common control enter into a partnership, the amounts of their contributions to, and distributions from, the partnership are subject to adjustment in order to reflect arm’s length results. Also subject to adjustment are partnership allocations, including allocations under section 704(c), and the relative magnitudes of the partners’ partnership interests in light of their respective contributions and the related controlled transactions. Accordingly, the amount of a remedial allocation pursuant to section 4 of this notice for controlled taxpayers that choose the Gain Deferral Method, or the amount of gain recognized if section 721(a) does not apply, potentially will be subject to adjustment by the IRS under section 482. In addition, when the conduct of partners, a partnership, or related controlled taxpayers is not reflected in, or is inconsistent with, the terms of the partnership agreement or any related agreements of the controlled taxpayers, the IRS may for purposes of an adjustment impute terms in the partnership or related agreements that

are consistent with the substance of the transaction. The imputation of terms may be appropriate, for example, when a partner provides services to the partnership but neither the partnership agreement nor any other agreement reflects the provision of such services.

For purposes of the best method analysis under § 1.482–1(c), the principles, methods, comparability, and reliability considerations set forth in § 1.482–7 are relevant to controlled transactions involving partnerships, as appropriately adjusted in light of the differences in the facts and circumstances between such arrangements and a cost sharing arrangement. Thus, depending on the facts and circumstances, an unspecified method based on a method specified in § 1.482–7(g)(1), as appropriately adjusted, may provide the most reliable measure of the arm’s length results of controlled transactions involving a partnership.

To the extent that controlled transactions involving a partnership, including contributions of tangible and intangible property and the provision of services by the controlled partners or their affiliates, are interrelated, an aggregate analysis of their combined effects is necessary under § 1.482–1(f)(2)(i) if the aggregate analysis provides the most reliable means of determining the arm’s length results for the controlled transactions.

When intangible property within the meaning of section 936(h)(3)(B) is contributed to a partnership, the IRS may consider making periodic adjustments under § 1.482–4(f)(2) in years subsequent to the contribution, without regard to whether the taxable year of the original transfer remains open for statute of limitations purposes. For purposes of making periodic adjustments in open years, the IRS may consider the consequences of what would have been appropriate adjustments to the commonly controlled partners’ interests in the partnership, or to any partnership allocations under section 704(b) or 704(c), in light of their respective contributions and the associated controlled transactions, even when those occurred in closed years. Furthermore, the IRS may consider the application of the periodic adjustment rules regardless of whether, under the regulations described in section 4 of this notice, section 721(a)

applies to the initial contribution of intangible property to the partnership. Where section 721(a) is inapplicable, the IRS may consider the application of the equivalent royalty rule under § 1.482–4(f)(6) to determine periodic adjustments to the recognition of gain on the contribution of the intangible property to the partnership.

In the absence of a basis, including the requirement of contemporaneous documentation, for establishing that the taxpayer reasonably concluded its valuation methods used for controlled transactions involving a partnership met the relevant measure of reliability set forth in § 1.6662–6(d), penalties potentially would apply under section 6662(e) or (h).