The U.S. Treasury has issued Notice 2005-29, providing transition relief for partnerships from new Section 470 of the Internal Revenue Code involving tax-exempt use property. Fund managers can rely on the relief provided from this notice for this filing season. This relief was issued in response to comments from taxpayers suggesting that certain partnerships may have difficulty applying this provision for 2004 with respect to certain property owned by partnerships or other pass-through entities. Treasury has requested comments from interested parties.
Section 470 of the Internal Revenue Code was created as part of the American Jobs Creation Act of 2004 and generally is designed to limit deductions attributable to property leased to tax-exempt entities. The law as written encompasses a broader group of taxpayers than was intended based upon the legislative history. Although the intent of the law was to apply to leased assets, to prevent sale-in lease-out arrangements, the application of Section 470 with respect to non-leased assets such as securities is unclear.
Applying Section 470 to hedge funds could create a situation whereby a portion of expenses of the fund attributable to tax-exempt use property may need to be deferred for U.S. tax purposes. In particular, the provision suspends certain losses at the partnership level to the extent that a partnership has a mix of taxable and tax-exempt/foreign partners. The provision releases any suspended losses upon the disposition of the tax-exempt use property that gave rise to the suspended loss. The application of this provision to non-leased non-depreciable property generally would have limited certain net deductions attributable to such property in an amount based on the tax-exempt/foreign partners “proportionate share” of income or gain with respect to such property. There is an exception to the application of Section 470 with respect to such property held by a partnership to the extent that the partnership agreement provides for certain “qualified allocations.”
However the partnership agreement for many hedge funds would not satisfy the requirements of this definition.
Treasury Notice 2005-29
For funds whose taxable year began before Jan. 1, 2005, the IRS will not apply Section 470 to disallow losses associated with property that is treated as tax-exempt use property solely as a result of the application of Section 168(h)(6) (this is the provision that arguably subjects non-depreciable non-leased assets held by a partnership to the application of Section 470).
The IRS and the Treasury Department request comments with respect to the application of Section 470 when a partnership or other pass-through entity is treated as holding tax-exempt use property because of the application of Section 168(h)(6). Specifically, comments are requested regarding (1) the extent to which property held by these entities should be aggregated in determining tax-exempt use losses under Section 470(a), (2) the manner in which deductions and income are allocated to a specific “property” for purposes of determining tax-exempt use loss, (3) whether tax-exempt use losses arising from property held by these entities are determined at the entity level or at the owner level, and (4) what types of entities other than partnerships should be considered pass-through entities subject to Section 470.
IRS Chief Counsel Donald L. Korb stated, “After listening to taxpayers’ concerns regarding the application of Section 470 to pass-through entities, we concluded that the limited transition relief provided in the notice is consistent with sound tax administration.”
Fund managers should be aware of the newly provided transition relief provided from Section 470 and need to consider the possible application of these rules in the future. We will work with all interested parties to provide comments regarding the application of Section 470 to hedge funds for taxable years beginning on or after Jan. 1, 2005.
Howard Leventhal, co-national director of Ernst & Young’s Asset Management Tax Practice, is a partner in Ernst & Young’s Global Hedge Fund Practice and is based in the firm’s financial services office.
Contact Bob Keane with questions or comments at: firstname.lastname@example.org”>.