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Friday, October 20, 2006


Under the substantial economic test, partnerships can generally allocate income and expenses between and among their partners as they like, provided that such allocations have a bottom line effect on the economic income or loss of the affected partners. Generally, an allocation of income or expense will be respected if (a) capital accounts are maintained as the IRS requires, (b) liquidation proceeds are distributed in accordance with capital account balances at the time of liquidation, and (c) provision is made for deficit capital account restoration obligations or qualified income offsets.

In newly issued regulations, the IRS indicated that compliance with these three requirements is NOT enough to uphold allocations of foreign taxes among partners. The IRS is concerned that foreign tax payments made by a partnership may be allocated to U.S. partners (who can make effective use of such taxes by obtaining a foreign tax credit for them that can be applied against U.S. income taxes) and away from foreign partners who cannot effectively use the foreign tax credit. To come within a safe harbor allocation under the new regulations, if the above three requirements are met an allocation of foreign taxes will be respected, but only if the allocation is also proportionate to a partner’s distributive share of the partnership income to which such taxes relate.

If an allocation cannot come within this safe harbor, the foreign taxes will be tested, and potentially reallocated, under the more general "partner interest" standard of Regs. §1.704 1(b)(3).

Preamble to TD 9292, 10/18/2006 ; Reg. § 1.704-1.

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