Preamble to Prop Reg REG-113604-18; Prop Reg § 1.864(c)(8)-1, Prop Reg § 1.897-7
IRS has issued proposed regs implementing Code Sec. 864(c)(8), as added by the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017), which provides that gain or loss of a nonresident alien individual or foreign corporation from the sale, exchange, or other disposition of a partnership interest is treated as effectively connected with the conduct of a trade or business within the U.S. to the extent that the transferor would have had effectively connected gain or loss if the partnership had sold all of its assets at fair market value as of the date of the sale or exchange.
Background—pre-TCJA law. Under pre-TCJA law, IRS, in Rev Rul 91-32, took the position that gain or loss of a foreign partner from a disposition of an interest in a partnership that conducts a trade or business through a fixed place of business or has a permanent establishment in the U.S. is treated as gain or loss effectively connected with the U.S. trade or business or is gain or loss attributable to the permanent establishment.
However, the Tax Court, in Grecian Magnesite Mining, Industrial & Shipping Co., (2017) 149 TC 63, rejected IRS’s position and held that a foreign corporation’s gain on the sale of an interest in a partnership that engaged in a U.S. trade or business wasn’t U.S. source income and wasn’t effectively connected with a U.S. trade or business.
Background—present law. Code Sec. 864(c)(8), added by the TCJA and effective for sales, exchanges, and dispositions on or after Nov. 17, 2017, generally overturns the result of Grecian Magnesite Mining. Code Sec. 864(c)(8)(A)provides that gain or loss of a foreign transferor from the transfer of an interest, owned directly or indirectly, in a partnership that is engaged in any trade or business within the U.S. is treated as effectively connected gain or loss (EC gain or loss) to the extent such gain or loss does not exceed the amount determined under Code Sec. 864(c)(8)(B). In general, Code Sec. 864(c)(8)(B) limits the amount of EC gain or loss to the portion of the foreign transferor’s distributive share of gain or loss that would have been EC gain or loss if the partnership had sold all of its assets at fair market value (FMV).
Code Sec. 864(c)(8)(C) provides that if a partnership described in Code Sec. 864(c)(8)(A) holds any U.S. real property interest (USPRI) at the time of the transfer of the partnership interest, then the gain or loss treated as EC gain or loss under Code Sec. 864(c)(8)(A) is reduced by the amount treated as EC gain or loss with respect to that USPRI under Code Sec. 897—effectively preventing gain or loss from a USPRI that is taxed under Code Sec. 897 from being taken into account a second time under Code Sec. 864(c)(8).
The TCJA also added Code Sec. 1446(f), effective for sales, exchanges, and dispositions after Dec. 31, 2017. Code Sec. 1446(f)(1) requires that the transferee of a partnership interest withhold 10% of the amount realized on the transferor’s disposition of the partnership interest (if any portion of the gain would be treated as EC gain) unless the transferor certifies that the transferor is not a foreign person.
Previous guidance. On Dec. 29, 2017, IRS issued Notice 2018-8, which temporarily suspended the requirement to withhold on amounts realized in connection with the sale, exchange, or disposition of certain interests in publicly traded partnerships (PTPs) in response to stakeholder concerns that applying Code Sec. 1446(f) to dispositions of interests in PTPs without guidance presented significant practical problems.
On Apr. 2, 2018, IRS released Notice 2018-29, which: a) announced an intent to issue proposed regs under Code Sec. 1446(f) that apply in the case of a disposition of a partnership interest that is not publicly traded and b) provided temporary guidance. (See “IRS guidance re withholding on dispositions of not-publicly-traded partnership interests.”)
New proposed regs. IRS has now issued proposed regs that set out how gain or loss under Code Sec. 864(c)(8)(A), and the limitation described in Code Sec. 864(c)(8)(B), are determined.
…Gain or loss under Sec. 864(c)(8)(A). To determine the amount of gain or loss under Code Sec. 864(c)(8)(A), the proposed regs generally require that a foreign transferor first determine its gain or loss on the transfer of a partnership interest (outside gain or loss). A foreign transferor may recognize capital gain or loss (outside capital gain or loss) and ordinary gain or loss (outside ordinary gain or loss) on the transfer of its partnership interest and must separately apply Code Sec. 864(c)(8) with respect to its capital gain or loss and its ordinary gain or loss.
The amount and character of outside gain or loss on the transfer of a partnership interest is determined under applicable tax law. (Prop Reg §1.864(c)(8)-1(b)(2)(i)) Under Code Sec. 741, on a sale or exchange of an interest in a partnership, gain or loss is recognized by the transferor and considered capital gain or loss except as otherwise provided in Code Sec. 751, which in turn provides that an amount received by a transferor of a partnership interest that is attributable to unrealized receivables or inventory items of the partnership (section 751 property) is considered ordinary income or loss. As a result, gain or loss on a sale or exchange of a partnership interest can comprise capital gain, capital loss, ordinary income, or ordinary loss (or a combination thereof).
In general, the proposed regs provide that a foreign transferor must determine the portion of its capital gain or loss, and the portion of its ordinary income or loss from section 751 property, that must each be characterized as EC gain or loss under Code Sec. 864(c)(8). (Prop Reg §1.864(c)(8)-1(b)) Under the proposed regs, a foreign partner’s EC gain or loss will not exceed its outside gain or loss on the sale of the interest as determined under Code Sec. 741 and Code Sec. 751 and the regs thereunder. So, the amount of gain or loss determined under Code Sec. 741 (before application of section 751) is not a limitation on the amount of gain or loss characterized as effectively connected with the conduct of a trade or business within the U.S. under the proposed regs.
Under Prop Reg §1.864(c)(8)-1(b)(2)(ii), gain or loss on the transfer of a partnership interest that is subject to tax as EC gain or loss is limited to gain or loss otherwise recognized under the Code—meaning that it does not include gain or loss that is not recognized by reason of one of more nonrecognition provisions in the Code. IRS noted in the Preamble that, while the proposed regs don’t contain special rules applicable to nonrecognition transactions, IRS is continuing to consider this issue and may propose rules addressing these transactions in the future.
…Limitation under Sec. 864(c)(8)(B). After outside gain and loss are determined under Prop Reg §1.864(c)(8)-1(b), the proposed regs provide three amounts that a foreign transferor must determine in order to derive the limitation in Code Sec. 864(c)(8)(B) against which the outside gain or loss is compared:
- with respect to each asset held by the partnership, the amount of gain or loss that the partnership would recognize in connection with a deemed sale to an unrelated party in a fully taxable transaction for cash equal to the asset’s FMV immediately before the partner’s transfer of its partnership interest;
- the amount of that gain or loss that would be treated as effectively connected gain or loss (deemed sale EC gain and loss); and
- the foreign transferor’s distributive share of the ordinary and capital components of any deemed sale EC gain and deemed sale EC loss.
After each of these aggregate amounts is determined, the proposed regs generally compare the foreign transferor’s outside gain or loss amounts with the relevant aggregate deemed sale EC gain or loss. This determination is made separately with respect to capital gain or capital loss and gain or loss treated as ordinary income or ordinary loss. (Prop Reg §1.864(c)(8)-1(b)(3))
The proposed regs require a foreign transferor to determine the amount of gain or loss that would arise in a deemed asset sale that would be treated as EC gain or loss. In general, gain or loss on the sale of personal property is effectively connected with the conduct of a trade or business within the U.S. if the gain is from sources within the U.S. and it satisfies the requirements of Code Sec. 864(c) and its regs. Accordingly, the proposed regs provide that Code Sec. 864 and its regs apply for purposes of determining whether gain or loss that would arise in a deemed asset sale would be treated as EC gain or loss. (Prop Reg §1.864(c)(8)-1(c)(2)(i))
The determination as to whether gain or loss from a deemed asset sale by the partnership would be from sources within or without the U.S., and whether that income would be treated as EC gain or loss, is based on certain factual determinations, including whether the gain or loss results from a sale that is attributable to an office or other fixed place of business in the U.S. The proposed regs provide that, for purposes of determining whether gain or loss recognized in connection with a deemed asset sale by the partnership would be from sources within or without the U.S., and thus whether that income would be treated as EC gain or loss, the deemed asset sale is treated as attributable to an office or fixed place of business in the U.S. maintained by the partnership.
As a result, deemed sale gain or loss generally would be treated as from sources within the U.S. However, Prop Reg §1.864(c)(8)-1(c)(2)(ii) provides a framework that prevents gain or loss from assets with no connection to the partnership’s trade or business within the U.S. from being converted into EC gain or loss.
Code Sec. 864(c)(8)(B) provides that a transferor partner’s distributive share of gain or loss on the deemed sale is determined in the same manner as the transferor partner’s distributive share of the “non-separately stated taxable income or loss of the partnership.” The proposed regs provide that a partner’s distributive share of gain or loss from the deemed sale is determined under all applicable Code sections (including Code Sec. 704), taking into account allocations of tax items applying the principles of Code Sec. 704(c), including any remedial allocations under Reg. §1.704-3(d), and any Code Sec. 743 basis adjustment pursuant to Reg. §1.743-1(j)(3). (Prop Reg §1.864(c)(8)-1(c)(3)(i)) IRS is continuing to consider whether Code Sec. 704 and its regs sufficiently prevent the avoidance of Code Sec. 864(c)(8) through allocations of EC gain or loss to specific partners, and requested comments on the subject.
…Coordination with Sec. 897. The proposed regs provide that the limitation on EC gain or loss in Code Sec. 864(c)(8)(B) is based on a deemed sale by the partnership of all of its assets, including all USRPIs held by the partnership, which are treated as effectively connected assets under Code Sec. 897. (Prop Reg § 1.864(c)(8)-1(c)(2)(i)) To coordinate the taxation of USRPIs under Code Sec. 897(g) and Code Sec. 864(c)(8), the proposed regs provide that when a partnership holds USRPIs and is also subject to Code Sec. 864(c)(8) because it is engaged in the conduct of a trade or business within the U.S. without regard to Code Sec. 897, the amount of the foreign transferor’s EC gain or loss will be determined under Code Sec. 864(c)(8) and not under Code Sec. 897(g), such that the reduction called for by Code Sec. 864(c)(8)(C) is not necessary. (Prop Reg §1.864(c)(8)-1(d))
…Rules for tiered partnerships. Where a foreign transferor transfers an interest in an upper-tier partnership that owns, directly or indirectly, an interest in one or more lower-tier partnerships that are engaged in the conduct of a trade or business within the U.S., then (i) the deemed sale gain or loss must be computed with respect to each lower-tier partnership, (ii) the amount of EC gain or loss that would be allocated to the upper-tier partnership must be determined, and (iii) the amount of gain or loss recognized by a foreign transferor that is treated as EC gain or loss under Prop Reg §1.864(c)(8)-1(c) must be determined by reference to the transferor’s distributive share of EC gain or loss arising from each lower-tier partnership. (Prop Reg §1.864(c)(8)-1(e)(1))
…Treaties. The proposed regs provide that the disposition of a foreign partner’s interest in a partnership, in whole or in part, is a disposition of all or part of a partner’s permanent establishment. Thus, to the extent the partnership’s assets form part of a foreign partner’s permanent establishment in the U.S., the permanent establishment paragraph of the gains article of an income tax treaty would generally preserve the U.S.’s taxing jurisdiction over the gain on the transfer of a partnership interest that is subject to tax under Code Sec. 864(c)(8). In addition, if an income tax treaty has a gains article that permits the U.S. to apply its domestic laws to tax gains or does not have a gains article, the treaty does not prevent the application of Code Sec. 864(c)(8).
If a gains article of an income tax treaty prohibits taxation of the gain from the disposition of any asset, the gains and losses from those assets will not be considered assets that form part of the permanent establishment, nor will they be taken into account in determining deemed sale EC gain or loss, for purposes of computing the Code Sec. 864(c)(8)(B) limitation. If the gains article of an applicable income tax treaty allows the taxation of gain from the disposition of a USRPI, the transfer of an interest in a partnership that holds a USRPI remains subject to Code Sec. 897(g) even if the transfer is not subject to Code Sec. 864(c)(8) (because the partnership’s assets are not treated as forming part of a permanent establishment in the U.S.) (Prop Reg §1.864(c)(8)-1(d))
…Anti-stuffing rule. The proposed regulations include an anti-stuffing rule in order to prevent inappropriate reductions in amounts characterized as effectively connected with the conduct of a trade or business within the U.S. under Code Sec. 864(c)(8).
Applicability dates. The proposed regs apply to transfers occurring on or after Nov. 27, 2017—the effective date of Code Sec. 864(c)(8). If any provision is finalized after June 22, 2019, IRS expects that such provision will apply only to transfers occurring on or after the date filed in the Federal Register.
References: For a foreign partner’s disposition of an interest in a partnership engaged in a U.S. business, see FTC 2d/FIN ¶ O-10610; United States Tax Reporter ¶8644.03.
