PwC alternatives alert

Section 470: Additional extension of transitional relief for certain partnerships treated as holding tax exempt

On December 13, 2006, the Internal Revenue Service issued Notice 2007-4 extending the transitional relief provided for partnerships and pass-thru entities under Notice 2006-2 for an additional year (i.e., for taxable years that begin before January 1, 2007). Section 470 of the Internal Revenue Code was added by the American Jobs Creation Act of 2004 (the "2004 Act") to address concerns relating to certain abusive leasing transactions. This provision was effective for any "leases" entered into after March 12, 2004.

Although this provision was intended to prevent perceived abuses related to certain leasing transactions, it inadvertently had an impact on many other non-abusive entities. These include hedge funds that have both direct or indirect tax-exempt entities and special allocations, such as the incentive allocations to the general partner, "side-pocket" investment allocations, and "stuffing" or "fill-up/down" allocation. A tax-exempt entity includes tax-exempt organizations and foreign persons not subject to tax. Section 470 contains language that disallows certain losses (directly allocable deductions and allocable interest) to all partnerships with more than one tax-exempt partner, which includes traditional tax-exempt organizations as well as foreign persons not subject to US tax.

During the 2006 legislative year, Congress has again been working to develop legislation that would exempt non-abusive transactions engaged in by partnerships from the application of Section 470. On September 29, 2006, the Tax Technical Corrections Act of 2006 was introduced in Congress. This legislation addresses, among other issues, the application of Section 470 to partnerships and other pass-thru entities. Comments had been solicited by the Chairpersons of the Senate Finance Committee and House Ways and Means Committee regarding the legislation, but as of the close of the congressional session this past December, no formal action had been taken.

Due to the ongoing and sometimes lengthy legislative process, the extension of transitional relief provided in Notice 2007-4 has been granted in an attempt to avoid any unintended consequences for non-abusive transactions. This additional extension of transitional relief is welcome given that many 2006 hedge fund tax returns would have been subject to the provision, and practical compliance would be extremely difficult. The hedge fund industry continues to seek a technical correction to the 2004 Act which excludes partnerships that do not have depreciable or amortizable property, or do not generate income that is directly allocable to depreciable or amortizable property.

PwC continues to work with the government towards a permanent resolution.

Specific advice and assistance may be sought from your PwC engagement team or from any of the Partners in our Alternative Investment Management Practice.