The U.S. IRS has published a practice unit on Transfers of Property to Partnerships with a Related Foreign Partner. The process overview of the practice unit includes the following:

U.S. persons can transfer built-in gain (appreciated) property in a wide variety of nonrecognition transactions, such as contributions to partnerships in exchange for an interest in the partnership. In general, IRC 721(a) provides for nonrecognition treatment when a partner contributes appreciated property to a partnership. However, in certain cases, such nonrecognition treatment could allow a U.S. person to use a partnership to inappropriately shift the tax consequences of pre-contribution gain attributable to appreciated property to a related foreign partner. With certain partnerships, namely partnerships with partners that are related to one another, there is heightened potential for such a shift to occur.

Specifically, a U.S. Transferor may inappropriately shift pre-contribution gain to a related foreign partner. This may occur when the partnership to which property is contributed adopts an IRC 704(c) allocation method other than the remedial method and/or uses valuation techniques that are inconsistent with the arm's length standard. For example, when a U.S partner contributes appreciated property with a zero tax basis, the disparity between the contributed property's Fair Market Value (FMV) and its tax basis at the time of contribution can limit the amount of tax depreciation or amortization that can be allocated to the related foreign partner. In other words, the maximum amount or ceiling of tax depreciation or amortization that can be allocated among the partners for zero basis property is zero (referred to as the ceiling rule). Therefore, if the contributed property's tax depreciation or amortization is zero, it follows that there is no tax depreciation or amortization to allocate to the related foreign partner. And, if the related foreign partner cannot be allocated its share of tax depreciation or amortization, then the tax consequences of the U.S partner's pre-contribution gain can be partially shifted to the related foreign partner due to the ceiling rule limitation.

To address this issue, the Treasury Department issued regulations under IRC 721(c). The IRC 721(c) regulations generally provide that a U.S. Transferor must recognize gain upon the transfer of appreciated property (tangible or intangible property) to certain partnerships (domestic or foreign) whose partners include foreign persons related to the U.S. Transferor unless certain requirements are met. Specifically, the U.S. Transferor will immediately recognize gain unless it elects to apply the gain deferral method. The gain deferral method, in turn, generally allows the U.S. Transferor to recognize the pre-contribution gain over time, but the gain can be accelerated in certain instances.

CONSULTATION: This practice unit focuses on the transfers of property to partnerships with related foreign partners. Generally, if the partnership only has domestic partners, then IRC 721(c) will not apply, but IRC 704(c) may apply. Please consult with the Partnership Practice Network for IRC 704(c) issues or for ceiling rule issues.

Click the following link for the International Practice Units page on the IRS website.