Today we welcome back a prior contributor to PT, Professor Andy Grewal, Associate Professor at University of Iowa College of Law. Andy often provides strong commentary on complicated and technical areas of the Code. Today’s post is no different, and is a combination of prior posts Professor Grewal wrote for Yale’s great regulatory blog Notice and Comment. In the post, Andy discusses the recent proposed regulations on management fee waiver transactions in private equity funds, and, specifically, provisions he argues are invalid because the timing under the regulations contradicts the clear statutory language. This is an incredibly hot topic among tax practitioners and the finance industry, and Andy raises interesting concerns that could impact the regulations generally. Steve.
In response to considerable public outcry, the Treasury and IRS recently issued proposed regulations on management fee waiver transactions (PT comment: for more information on management fee waiver transactions, see Prof. Grewal’s article, Mixing Management Fee Waivers with Mayo). Practitioner comments have focused heavily on whether the regulation’s various factors properly follow those described in the legislative history of Section 707(a)(2)(A).
This post examines a largely overlooked provision of the regulations that, if finalized, would plainly contradict the governing statute. It then considers how any challenge to that provision might arise and how any such challenge might lead to a broad invalidation of the Section 707(a)(2)(A) regulations.read more...
I. The Invalid Fee Waiver Regulation
Under the proposed fee waiver regulations, an allocation to a private equity firm regarding its waiver interest (the additional profits interest received in exchange for waiving a fee) may be treated as a payment to an outsider, generating ordinary income, rather than as an allocation of partnership long-term capital gain. The IRS’s approach here is generally sound, but a provision in the regulations, Prop. Reg. 1.707-2(b)(i), departs from the statute on an important timing issue.
The relevant statute, Section 707(a)(2)(A), grants the Treasury the authority to issue regulations that subject partner-partnership transactions to outsider treatment under Section 707(a)(1). That is,
(i) a partner performs services for a partnership or transfers property to a partnership,
(ii) there is a related direct or indirect allocation and distribution to such partner, and
(iii) the performance of such services (or such transfer) and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership,
such allocation and distribution shall be treated as a transaction described in [Section 707(a)(1)].
As the bolded language shows, the statute contemplates regulations that apply outsider treatment when there has been both an “allocation and distribution.” The statute uses that phrase 3 times, and Section 707(a)(2)(A)(iii) hammers that point home — the allocation and distribution must be “viewed together” to determine if it’s appropriate to take the transaction outside of the partner-partnership framework.
For the IRS, this apparently creates administrative problems, because a partnership might allocate income to a partner in one year, but any related distribution may take place in a later taxable year. Citing these administrative problems, the proposed regulations nix the statute’s distribution requirement. Under Prop. Reg. 1.707-2(b)(i), the transaction is tested “at the time the arrangement is entered into.” So, under the regulation, an income allocation may be recharacterized without regard to any related distribution.
As a pure textual matter, the regulation does not comply with the statute. The statutory language requires an “allocation and distribution” that are “viewed together.” If the IRS focuses on only the allocation and attempts to alter its tax consequences, without considering the related distribution, it has exceeded the regulatory authority granted by Section 707(a)(2)(A). The IRS cannot “view together” two parts of a transaction, as required by the statute, if it looks at only one part. Under Step One of the familiar Chevron framework, Prop. Reg. 1.707-2(b)(i), if finalized, will fail.
The IRS might offer rejoinders to this conclusion. For example, it might make a policy-based argument and say it’s unfair to delay the determination of tax consequences until a distribution is made, especially in light of the apparent administrative problems associated with a wait-and-see approach.
However, it’s just as easy to imagine that Congress wanted to limit the IRS’s authority to circumstances where a distribution occurs soon after any partnership allocation is made. After all, if a partner and partnership are using the distributive share regime as a mere funnel for payments, with the intention of avoiding capitalization requirements or of converting the character of a payment, one would expect that a distribution will occur soon after the related allocation. If instead a distribution occurs, say, 10 years after an allocation, that would be a fairly strong sign that the allocation/distribution were not used as a device to funnel payments. In other words, it’s quite easy to see why the temporal relationship between the allocation and distribution are relevant to whether a transaction should be moved to the Section 707(a)(1) framework. Congress, in fact, was principally concerned with relatively simple transactions when it enacted Section 707(a)(2)(A), not complex fee waiver transactions.
This is not to say that Congress’s policy in enacting Section 707(a)(2)(A) was the best one. Maybe the statute should be amended such that it extends regulatory authority when “an allocation and a reasonably anticipated distribution, viewed together” show that the parties acted as strangers. However, those are not the words that Congress has chosen. And any pure policy arguments supporting the negation of the distribution requirement can just as easily be matched with a policy argument emphasizing the insights yielded by viewing an allocation and distribution together.
To find some statutory support for its approach, the IRS refers to the underlying policies of Section 704(b). Under that statute, an allocation generally must have “substantial economic effect” to be respected. The relevant regulations contemplate that an allocation to a partner will enjoy “economic effect” when the partner essentially enjoys the benefit or bears the burden associated with an allocation of income or loss. See Treas. Reg. 1.704-1(b)(2)(ii)(a). Thus, it’s not enough to nominally allocate income to the partner — the partnership must increase his capital account as a result of the allocation and must make distributions consistent with the balance in that account. See Treas. Reg. 1.704-1(b)(2)(ii)(b)(2). In other words, an income allocation comes with some “distribution rights,” via the capital account maintenance rules.
The proposed regulations seize on these distribution rights to negate the statute’s distribution requirement. That is, “the Treasury Department and the IRS believe that a premise of section 704(b) is that an income allocation correlates with an increased distribution right, justifying the assumption that an arrangement that provides for an income allocation should be treated as also providing for an associated distribution for purposes of applying section 707(a)(2)(A).” 80 Fed. Reg. 43652, 43654 (July 23, 2015).
The IRS’s assumption that a distribution will usually follow an allocation may very well be justified, but it does not square with the statute. Again, Congress plainly required an “allocation and a distribution” that are “viewed together.” The statute does not refer to distributions that are “anticipated” or “reasonably assumed.”
Nor does the statutory text allow for any equation between a “distribution right” and a “distribution.” When Congress passed Section 707(a)(2)(A), Section 704(b) and its substantial economic effect requirements were already in place. That is, Congress already knew that an “allocation” contemplated distribution rights, because Congress itself had passed the law under which the capital account maintenance regulations had been issued. So, by including in Section 707(a)(2)(A) the words “allocation and distribution” and “view[ing] together,” Congress must have meant something beyond an allocation that enjoys substantial economic effect. Otherwise it would have referred only to an “allocation.”
The IRS might nonetheless argue that when Congress referred to an “allocation” in Section 707(a)(2)(A), it was speaking of sham allocations, and not those that enjoy substantial economic effect. But that wouldn’t make much sense. If an allocation lacks substantial economic effect, it will not be respected under Section 704(b) in the first instance, and the parties’ attempt to manipulate the allocation rules would already be defeated, without regard to Section 707(a)(2)(A). Thus, the statute’s references to a “distribution” and to viewing the transactions “together” add further elements to the statute which the IRS must honor.
Prop. Reg. 1.707-2(b)(i) may reflect a good policy (a debatable point), but it does not square with the law. In recharacterizing any income allocated to a private equity firm’s waiver interest, the regulation should be re-drafted such that it follows the statutory requirements and views together the allocation and the related distribution. The IRS will continue to enjoy the authority to recharacterize allocations and distributions on waiver interests — the issue here relates to when to make the relevant determinations, not whether to do so. And if, as expected, private equity firms quickly receive distributions on their waiver interests, then the administrative problems might be negligible. If distributions are severely delayed and the IRS still wishes to act under Section 707(a)(2)(A), it should request authority from Congress. Its current regulation, if made final, reflects an invalid interpretation of the existing statute.
II. Challenging the Regulation
Any allegation of a regulation’s invalidity usually comes with some uncertainty, given the generally deferential framework employed by courts in examining agency rulemaking. But here, the IRS has taken an eraser to statutory language. Perhaps some on the Tax Court would uphold the regulation under a strong purposive approach, but that tribunal has gone through somewhat of a renaissance in the administrative law area, as evidenced by the Altera decision. Thus, the Tax Court may very well view Prop. Reg. 1.707-2(b)(i) through the same lens that the Supreme Court and the circuit courts would view it. Under their approach to statutory interpretation, they do not bless an agency’s rewrite of a statute especially where, as here, following the plain language is consistent with the statutory structure and is supported by plausible policy concerns.
The regulations thus seem poised for a challenge. The Preamble to the proposed regulations acknowledges that some “distributions may be subject to independent risk,” and taxpayers who face risky distributions may scoff at the premature re-characterization of their income allocations. Additionally, two comment letters raise concerns with Prop. Reg. 1.707-2(b)(i), so presumably some taxpayers will be adversely affected. See Comments of the Tax Section of the Connecticut Bar Association (Oct. 8, 2015); Comments of the Tax Section of the New York State Bar Association (Nov. 13, 2015).
Although the invalidation of a regulation always raises a significant issue, the stakes could be far higher if the private equity industry mounts a pre-enforcement challenge to the regulations. The IRS apparently believes it must eliminate the statute’s “distribution” and “view[ing] together” requirements to make the regulations administratively workable. Consequently, Prop. Treas. Reg. 1.707-2(b)(i) might not be severable from the remainder of the regulations. If that is so, a successful challenge to the final version of Prop. Treas. Reg. 1.707-2(b)(i) could lead to the invalidation of all the Section 707(a)(2)(A) regulations.
To address this issue, the IRS might include a severability provision in its fee waiver regulations, stating that if a court invalidates Prop. Treas. Reg. 1.707-2(b)(i), it should not bring down the rest of the regulations. But the effect of such provisions remains uncertain, as detailed in a new article by recent Yale Law School graduate Charles Tyler and by former Yale Law School Professor Donald Elliott found here.
Of course, taxpayers usually very wisely avoid pre-enforcement challenges to Treasury regulations, especially given the difficulties associated with standing. Thus, a deficiency or refund action reflects the most natural and likely forum through which to invalidate Prop. Treas. 1.707-2(b)(i).
Nonetheless, the private equity industry seems unusually well-coordinated, even aggressive, when it comes to preserving their tax benefits. Additionally, the legal fees associated with a pre-enforcement challenge reflect an exceptionally tiny fraction of the industry’s income, and the benefits of a victory would be considerable. Consequently, the possibility of a pre-enforcement challenge might be explored. See generally, Patrick J. Smith, Challenges to Tax Regulations: The APA and the Anti-Injunction Act, 147 Tax Notes 915 (2015). Any related litigation would involve procedural and severability issues that are as uncertain as they are fascinating.