Treasury and IRS Propose Rules for Foreign Partners in Partnerships Engaged in a U.S. Trade or Business

Summary

Recently, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury), proposed regulations implementing Section 864(c)(8) of the Code (the Proposed Regulations). The Proposed Regulations affect certain foreign persons that recognize gain or loss from the sale or exchange of an interest in a partnership that is engaged in a trade or business within the United States. The Proposed Regulations also affect partnerships that, directly or indirectly, have foreign partners.

 

Details

Section 864(c)(8), which was added to the Code by the Tax Cuts and Jobs Act (TCJA), provides that gain or loss of a nonresident alien individual or foreign corporation (a foreign transferor) from the sale, exchange, or other disposition (transfer) of a partnership interest is treated as effectively connected (EC) with the conduct of a trade or business within the United States (EC gain or EC loss) to the extent that the transferor would have had EC 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 (deemed sale). Section 864(c)(8) essentially overturns the holding in Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017), appeal argued, No. 17-1268 (D.C. Cir. Oct. 9, 2018). For a discussion of Grecian, see our July 2017 Tax Alert.
 
To determine the amount of gain or loss described in Section 864(c)(8)(A), generally, the Proposed Regulations require that a foreign transferor first determine its gain or loss on the transfer of a partnership interest (outside gain and outside loss). For this purpose, the Proposed Regulations provide that outside gain or loss is determined under all relevant provisions of the Code and the regulations thereunder.
 
In general, the Proposed Regulations 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,^[1] that must each be characterized as EC gain or loss under Section 864(c)(8).^[2] The Proposed Regulations provide that 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 Sections 741 and 751 and the regulations thereunder.

The Proposed Regulations provide that the 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.^[3] 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.
 
After outside gain and loss are determined under Prop. Reg. §1.864(c)(8)-1(b), the Proposed Regulations set forth three amounts that a foreign transferor must determine to derive the limitation in Section 864(c)(8)(B) against which the outside gain or loss is compared: (1) 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 fair market value immediately before the partner’s transfer of its partnership interest; (2) the amount of that gain or loss that would be treated as EC gain or loss (deemed sale EC gain and deemed sale EC loss); and (3) the foreign transferor’s distributive share of the ordinary and capital components of any deemed sale EC gain and deemed sale EC loss. The Proposed Regulations refer to the separate sums of the foreign transferor’s distributive shares of the ordinary and capital components of deemed sale EC gain and deemed sale EC loss items for all assets, determined at the level of the foreign transferor, as aggregate deemed sale EC capital gain, aggregate deemed sale EC capital loss, aggregate deemed sale EC ordinary gain, and aggregate deemed sale EC ordinary loss.
 
After each of these aggregate amounts is determined, the Proposed Regulations implement the limitation described in Section 864(c)(8)(B), generally, by comparing 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. Thus, for example, a foreign transferor would compare its outside capital gain to its aggregate deemed sale EC capital gain, treating the former as EC gain only to the extent it does not exceed the latter.^[4]
 
The Proposed Regulations provide that Section 864 and the regulations thereunder 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.^[5]
 
The Proposed Regulations 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 United States, 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 United States maintained by the partnership. To prevent this rule from potentially converting gain or loss from assets with no connection to the partnership’s trade or business within the United States into EC gain or loss, the Proposed Regulations provide that gain or loss from the deemed sale of a partnership asset is not treated as EC gain or loss if (1) no income or gain previously produced by the asset was taxable as EC with the conduct of a trade or business within the United States by the partnership (or a predecessor of the partnership) during the ten-year period ending on the date of the transfer, and (2) the asset was not used, or held for use, in the conduct of a trade or business within the United States by the partnership (or a predecessor of the partnership) during the ten-year period ending on the date of transfer.^[6]
 
The Proposed Regulations provide that a partner’s distributive share of gain or loss from the deemed sale 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 Treas. Reg. §1.704-3(d), and any Section 743 basis adjustment pursuant to §1.743-1(j)(3).
 
The Proposed Regulations clarify that they do not apply to prevent any portion of gain or loss recognized on the transfer of a partnership interest from being treated as EC gain or loss under other provisions of the Code (subject to a special rule coordinating the application of Section 864(c)(8) and Section 897).
 
To coordinate the taxation of U.S. real property interests under Sections 897(g) and 864(c)(8), the Proposed Regulations provide that when a partnership holds U.S. 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 EC 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.^[7]
 
The Proposed Regulations provide that if 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 United States, then the deemed sale gain or loss must be computed with respect to each lower-tier partnership, the amount of EC gain or loss that would be allocated to the upper-tier partnership must be determined, and the amount of gain or loss recognized by a foreign transferor that is treated as EC gain or loss under proposed §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.^[8]
 
The Proposed Regulations also 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 EC gain or loss by applying the principles of the proposed regulations, including the tiered partnership rules described in Prop. Reg. §1.864(c)(8)-1(e)(1).
 
The Proposed Regulations 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 United States, the permanent establishment paragraph of the gains article would generally preserve the United States’ taxing jurisdiction over the gain on the transfer of a partnership interest that is subject to tax under Section 864(c)(8). In addition, if an income tax treaty has a gains article that permits the United States to apply its domestic laws to tax gains or does not have a gains article, the treaty does not prevent the application of Section 864(c)(8).
 
The Proposed Regulations include an anti-stuffing rule applicable to both these regulations and Section 897. This rule is included to prevent inappropriate reductions in amounts characterized as EC with the conduct of a trade or business within the United States under Section 864(c)(8) or Section 897. A cross-reference to this rule is also included in the proposed regulation under Section 897.
 
The Proposed Regulations apply to transfers occurring on or after November 27, 2017, the effective date of Section 864(c)(8).^[9] If any provision is finalized after June 22, 2019, Treasury expects that such provision will apply only to transfers occurring on or after the date the provision is published in the federal register.^[10]
 

 

BDO Insights

While the Proposed Regulations provide guidance with regard to Section 864(c)(8), it should be noted that the Proposed Regulations do not address the corresponding withholding provisions under Section 1446(f), which was also enacted by the TCJA. The preamble to the Proposed Regulations states that future guidance under Section 1446(f) should be released soon.