IRS reallocates losses of joint venture among foreign and domestic partners.

• Author: Carrasco, Jose

The IRS released a Chief Counsel Advice memorandum (CCA 201741018) on Oct. 13, 2017, that addressed the allocation of partnership losses where certain partners had negative capital account balances. The IRS determined that a joint venture's allocation of certain losses failed to meet the substantial economic effect test under Sec. 704(b) and that those losses must instead be allocated in accordance with the partners' interests in the partnership. The IRS also considered whether the laws of a foreign jurisdiction effectively imposed a deficit restoration obligation on some of the partners. The IRS concluded that the foreign jurisdiction's requirement that certain partners contribute additional capital to the joint venture to avoid its liquidation was insufficient to cause those partners to bear the economic risk of losses in excess of their positive capital accounts.

An allocation of income, gain, loss, or deduction set forth in a partnership agreement will be respected if the allocation has substantial economic effect. If the allocation does not have substantial economic effect, a partner's distributive share is determined based on the partner's interest in the partnership, taking into account all the facts and circumstances.

Regs. Sec. 1.704-1(b)(2) provides a two-part analysis to determine whether an allocation has substantial economic effect: (1) The allocation must have economic effect, and (2) the economic effect must be substantial. In the CCA, the IRS primarily focused on whether the joint venture's allocation of losses had economic effect. Regs. Sec. 1.704-l(b)(2)(ii)(b) sets forth three requirements that must be present in a partnership agreement for an allocation to meet the economic effect test: (1) The partnership must maintain capital accounts in accordance with the rules set forth in Regs. Sec. 1.704-l(b)(2)(iv); (2) liquidating distributions must be made in accordance with the partners' positive capital account balances; and (3) the partners must be unconditionally obligated to restore a deficit balance in their capital accounts upon the liquidation of the partnership.

In the CCA, the IRS described a U.S. parent corporation (US Parent) and a foreign parent corporation (Foreign Parent) that agreed to jointly develop resources in a foreign country. To carry out the joint venture, US Parent and Foreign Parent formed a limited liability company under the foreign country's local law and filed an election to treat the joint venture...