The U.S. Treasury Department and IRS released a version of proposed regulations (REG-113604-18) as guidance under section 864(c)(8) concerning tax on the sale of U.S. trade or business partnership interests on a look-through basis.
Section 864(c)(8) was added to the Code by the new U.S. tax law (Pub. L. No. 115-97, date of enactment December 22, 2017)—the law that is at times referred to as the “Tax Cuts and Jobs Act” (TCJA).
Read the proposed regulations [PDF 150 KB] (36 pages)
This report provides initial impressions about the proposed regulations.
The IRS in 1991 issued Rev. Rul. 91-32 and concluded that a foreign partner’s capital gain or loss on the sale of a partnership interest is properly treated as effectively connected with a U.S. trade or business if and to the extent that a sale of the underlying assets by the partnership would have resulted in effectively connected income for the foreign partner.
In 2017, the U.S. Tax Court in Grecian Magnesite Mining v. Commissioner refused to follow the revenue ruling in determining that a foreign partner was not subject to U.S. tax on a sale of a partnership interest (to the extent the gain was not attributable to U.S. real property interests).
In response, section 864(c)(8) was enacted in the 2017 tax law to provide that gain or loss on a sale of a partnership interest by a foreign person is treated as effectively connected with a U.S. trade or business to the extent that the foreign person would have had effectively connected gain or loss had the partnership sold its underlying assets.
A separate provision of the new law—section 1446(f)—requires that the transferee of a partnership interest withhold 10% of the amount realized on a sale or exchange of the interest unless the transferor certifies that it is not a foreign person and provides a U.S. taxpayer identification number. If the transferee fails to withhold the correct amount, the new law imposes an obligation on the partnership to deduct and withhold from distributions to the transferee partner an amount equal to the amount the transferee failed to withhold, plus interest.
In December 2017, the IRS released Notice 2018-08 (the “PTP Notice”). The PTP Notice temporarily suspends the requirement to withhold on amounts realized in connection with the sale, exchange, or disposition of certain interests in publicly traded partnerships.
In April 2018, the IRS released Notice 2018-29 that announced an intent to issue proposed regulations under section 1446(f) that apply in the case of a disposition of a partnership interest that is not publicly traded and provided temporary guidance.
The proposed regulations generally:
The proposed regulations essentially break down the calculation of a foreign transferor’s effectively connected gain or loss into four steps:
Interaction with section 751
In determining a foreign transferor’s “outside gain” or “outside loss,” the proposed regulations provide that a foreign transferor must take the general recharacterization rule under section 751 into account.
In general, under section 751 the sale or exchange of a partnership interest can give rise to ordinary income or loss to the extent attributable to the transferor’s share of the partnership’s “hot” assets (i.e., ordinary assets such as inventory and unrealized receivables, which is broadly defined for this purpose). As a result, the proposed regulations treat a foreign transferor as having two separate limits on the amount of its effectively connected gain or loss:
Non-separately stated taxable income or loss
Section 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.”
As noted in the preamble of the proposed regulations, the term “non-separately stated taxable income or loss of the partnership” is not defined in the Code or regulations. The proposed regulations provide that a partner’s distributive share of any items of deemed sale effectively connected gain or deemed sale effectively connected loss is determined under all applicable Code sections (including section 704), taking into account allocations of tax items applying the principles of section 704(c), including any remedial allocations under Reg. section 1.704-3(d) and any section 743 basis adjustment pursuant to Reg. section 1.743-1(j)(3).
The IRS and Treasury have proposed this approach because, according to the preamble, applying section 704 more closely ties the results of the deemed sale to the economic results of an actual sale, as compared (for example) to an approach that did not consider special allocations or considered only a partner’s share of ordinary business income, which would distort the economic agreement among the partners.
The IRS and Treasury are considering whether section 704 and the regulations thereunder adequately prevent the avoidance of the purposes of section 864(c)(8) through allocations of effectively connected gain or loss to specific partners and whether additional guidance is necessary to prevent abuse. Comments are requested.
Neither section 864(c)(8) nor the proposed regulations address the source of gain or loss from the transfer of a partnership interest. The proposed regulations, however, provide that gain or loss recognized on the transfer of an interest in a partnership that is engaged in a trade or business within the United States may be treated as effectively connected gain or loss even if it is from sources without the United States. Treasury and the IRS have requested comments as to whether, and what, additional guidance is necessary regarding the source of gain or loss subject to section 864(c)(8).
By directly characterizing gain on the sale of a partnership interest as ECI, section 864(c)(8) bypasses the mechanism of attributing the sale to an office or fixed place of business of the partnership (as the IRS argued in Rev. Rul. 91-32) which would result in U.S. sourcing by virtue of section 865(e)(3). This leads to the somewhat anomalous possibility of “foreign source ECI.” The significance of this relates primarily to the possibility of claiming foreign tax credits against the U.S. tax liability in the event that the gain is also subject to a foreign tax.
The proposed regulations provide that the gain or loss on the transfer of a partnership interest that is subject to tax as effectively connected gain or loss is limited to gain or loss otherwise recognized under the Code. When a nonrecognition provision results in a foreign transferor recognizing only a portion of its gain or loss on the transfer of an interest in a partnership, section 864(c)(8) may apply with respect to the portion of the gain or loss recognized.
The preamble notes that while section 864(c)(8)(E) authorizes regulations or other guidance with respect to the application of section 864(c)(8) to nonrecognition transactions, the proposed regulations do not contain special rules applicable to nonrecognition transactions. According to the preamble, Treasury and the IRS recognize that certain nonrecognition transactions may have the effect of reducing gain or loss that would be taken into account for U.S. federal income tax purposes—for example, if a partnership that conducts a trade or business within the United States owns property not subject to tax under section 871(b) or 882(a) in the hands of a foreign partner, the partnership may distribute that property to the foreign partner rather than a U.S. partner. Comments are requested regarding whether other Code provisions adequately address transactions that rely on section 731 distributions to reduce the scope of assets subject to U.S. federal income taxation, and Treasury and the IRS may propose rules addressing these types of transactions.
The request for comments suggests that Treasury and the IRS may be considering something like a section 751(b) exchange approach to policing disproportionate distributions of ECI-generating property. As with section 751(b) itself, tax professionals expect such an approach, if applied broadly, would entail significant complexity. While Treasury and the IRS’s concern is understood, a more general principal purpose anti-abuse rule might be a more appropriate balance between their concern and administrative complexity.
In the proposed regulations, the limitation on effectively connected gain or loss in section 864(c)(8)(B) is based on a deemed sale by the partnership of all of its assets—including all United States real property interests held by the partnership—which are treated as effectively connected assets under section 897. To coordinate the taxation of United States real property interests under sections 897(g) and 864(c)(8), the proposed regulations provide that when a partnership holds United States real property interests and is also subject to section 864(c)(8) because it is engaged in the conduct of a trade or business within the United States (without regard to section 897), the amount of the foreign transferor’s effectively connected gain or loss will be determined under section 864(c)(8)—and not under section 897(g). Therefore, the reduction called for by section 864(c)(8)(C) is not necessary.
The proposed regulations clarify that when a foreign transferor is a partner in an upper-tier partnership, and the upper-tier partnership transfers an interest in a lower-tier partnership that is engaged in the conduct of a trade or business within the United States, the upper-tier partnership must determine its effectively connected gain or loss by applying the principles of the proposed regulations.
The proposed regulations state that for purposes of applying any U.S. income tax treaty, the transfer of an interest in a partnership that has a permanent establishment in the United States will be treated in the same manner as a sale of property forming part of a permanent establishment or a sale of the permanent establishment itself. Rules are provided that generally equate the gain attributable to the permanent establishment with effectively connected gain as otherwise computed under the regulations (but adjusted to reflect items which might be effectively connected income but yet exempt under the treaty).
Neither section 864(c)(8) nor the accompanying legislative history speaks to the application of U.S. income tax treaties to sales of partnership interests. The position taken by the proposed regulations is generally consistent both with Rev. Rul. 91-32 and with language included in the Technical Explanation to a number of U.S. income tax treaties negotiated after the revenue ruling was issued.
The proposed regulations include an anti-stuffing rule applicable to both these proposed regulations and section 897. This is intended to prevent inappropriate reductions in amounts characterized as effectively connected with the conduct of a trade or business within the United States under section 864(c)(8) or section 897.
The preamble notes that there is no guidance concerning withholding measures in the proposed regulations, and that the IRS and Treasury intend to issue guidance under section 1446(f) “expeditiously.”
The proposed regulations apply to transfers occurring on or after November 27, 2017, the effective date of section 864(c)(8). If any provision is finalized after June 22, 2019, the Treasury Department and IRS expect that such provision will apply only to transfers occurring on or after the date when the regulations are filed with the Federal Register.