Treasury Issues Final Regulations Under Section 864(c)(8)
Summary
On September 21, 2020, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) released an early version for publication in the Federal Register, final regulations (TD 9199) that provide guidance for 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 final regulations also affect partnerships that, directly or indirectly, have foreign persons as partners.
Background
On December 27, 2018, Treasury published proposed regulations (REG-113604-18) under Section 864(c)(8) of the Internal Revenue Code in the Federal Register (83 FR 66647). The proposed regulations provide rules for determining the amount of gain or loss treated as effectively connected with the conduct of a trade or business within the United States (effectively connected gain or effectively connected loss) under Section 864(c)(8), including certain rules that coordinate Section 864(c)(8) with other relevant sections of the Code. For a summary discussion of the proposed regulations, see our January 2019 tax alert.
The final regulations retain the basic approach and structure of the proposed regulations with certain revisions. Some of the key revisions are summarized below.
Final Regulations Shed Additional Light on Application of Section 864(c)(8)
While the final regulations retain the basic framework of the proposed regulations, including the factual determinations regarding office attribution provided in proposed Treasury Regulation §1.864(c)(8)-1(c)(2)(i), the final regulations adjust their effects by adding rules for sourcing gain or loss from specific assets that may be particularly difficult to source in a deemed sale.[1]
The final regulations provide that deemed sale effectively connected (EC) gain and loss is determined by applying Section 864 and the regulations thereunder.[2] The final regulations retain the “ten-year exception” in proposed §1.864(c)(8)-1(c)(2)(ii) as an exception to the determination of deemed sale EC gain and loss under §1.864(c)(8)-1(c)(2)(i)(A). The final regulations modify the relevant testing period for the ten-year exception to account for a partnership (including a predecessor of the partnership) that has not existed for at least ten years, or that has not held an asset for at least ten years, by shortening the relevant testing period to the lesser of the ten-year period ending on the date of the transfer or the period during which the partnership (and a predecessor of the partnership) held the asset.[3] In addition, to ensure that the ten-year exception is properly applied, the final regulations also modify the relevant testing period to include any period during which the foreign transferor (and a predecessor of the foreign transferor) held the asset.[4]
Proposed §1.864(c)(8)-1(c)(2)(i) treats all gain or loss from the deemed sale of an asset as attributable to an office or other fixed place of business maintained by the partnership in the United States, and does not treat inventory property as sold for use, disposition, or consumption outside the United States in a sale in which an office or other fixed place of business maintained by the partnership in a foreign country materially participated. The final regulations clarify that the general rule applies only for purposes of applying Section 865(e)(2)(A) to personal property held by the partnership on the date of the deemed sale.[5] Second, the final regulations provide additional sourcing rules for determining the foreign source portion of deemed sale gain and loss attributable to specific assets included in the deemed sale.[6] The specific assets are inventory, intangibles, and depreciable personal property. The final regulations also clarify that if the partnership does not maintain an office or other fixed place of business in the United States (within the meaning of Section 864(c)(5)(A) and §1.864-7), neither the U.S. office attribution described in §1.864(c)(8)-1(c)(2)(ii)(A), nor the additional sourcing rules described in §1.864(c)(8)-1(c)(2)(ii)(B) through (E), will apply.[7] Finally, the final regulations reorganize the proposed regulations to account for the changes made by the final regulations, and the phrase in proposed §1.864(c)(8)-1(c)(2)(i) regarding use, disposition, or consumption outside the United States is removed to conform with changes made to the general rule and the addition of a specific inventory sourcing rule.
To the extent that deemed sale gain or loss is attributable to inventory, intangibles, or depreciable personal property, the sourcing result for these assets is determined by first applying §1.864(c)(8)-1(c)(2)(ii)(A) and then, to the extent applicable, the asset-specific rules provided in §1.864(c)(8)-1(c)(2)(ii)(B) through (D), or the material change in circumstances rule provided in §1.864(c)(8)-1(c)(2)(ii)(E). Accordingly, the U.S. office attribution rule described in §1.864(c)(8)-1(c)(2)(ii)(A) applies to these assets only to the extent that the deemed sale gain or loss exceeds the relevant foreign source portion determined under the relevant rule provided in §1.864(c)(8)-1(c)(2)(ii)(B) through (E).
Reg. §1.864(c)(8)-1(c)(2)(ii)(B) provides a look-back rule for determining the foreign source portion of deemed sale gain or loss attributable to inventory property (as defined in Section 865(i)(1), but not including gain sourced by reference to Section 865(c)(2)) that is held by the partnership on the date of the deemed sale. Specifically, the general rule provided in §1.864(c)(8)-1(c)(2)(ii)(A) will not apply, and the deemed sale of inventory property will not be treated as attributable to an office or other fixed place of business maintained by the partnership in the United States, to the extent of foreign source inventory gain or loss. This amount is determined by multiplying deemed sale gain and loss attributable to inventory by a fraction that determines the foreign source inventory ratio. The numerator of the fraction includes the gross income of the partnership that is attributable to foreign source gain or loss from inventory property (as determined under the rules of Sections 865(b) and 865(e)) sold within the shorter of the period comprised of the partnership’s three taxable years immediately preceding the date of the deemed sale, or the existence of the partnership (measured by partnership taxable years); the denominator of the fraction is the total gross income of the partnership that is attributable to inventory over that period.
To minimize the difficulty of applying the sourcing rules to intangible property and to provide more certainty, the final regulations provide a separate rule for intangibles (including going concern value) that determines the foreign source portion of deemed sale gain or loss attributable to intangibles by using a proxy method that is based on the source of the partnership’s historic gross ordinary income. Reg. §1.864(c)(8)-1(c)(2)(ii)(C) provides a look-back rule for determining the foreign source portion of deemed sale gain or loss attributable to an intangible (as defined in Section 865(d)(2)) held by the partnership on the date of the deemed sale. This rule is similar to the look-back rule for inventory property because it provides that the deemed sale of an intangible will not be treated as attributable to an office or other fixed place of business maintained by the partnership in the United States to the extent of a foreign source amount. This amount is determined by multiplying deemed sale gain or loss attributable to an intangible by the foreign source intangible ratio. The numerator of the foreign source intangible ratio includes the foreign source gross ordinary income of the partnership (other than from dispositions of depreciable or amortizable property) during the shorter of the period comprised of the partnership’s three taxable years preceding the date of the deemed sale or the existence of the partnership (measured by partnership taxable years), to the extent that such income was not effectively connected with the conduct of a trade or business within the United States; the denominator includes the total gross ordinary income of the partnership (other than from dispositions of depreciable or amortizable property) during that period.[8] This foreign source intangible ratio looks specifically to the historic gross ordinary income of the partnership (as opposed to all the historic gross income of the partnership) in order to more accurately reflect the partnership’s income derived from the use of the intangibles in the ordinary course of its trade or business. This rule does not apply to the extent of any depreciation adjustments (as defined in Section 865(c)(4)(B)) with respect to an amortizable intangible; instead, the rules regarding depreciable personal property will apply to such adjustments.
The final regulations include special rules for the foreign source inventory ratio and the foreign source intangible ratio. First, the foreign source inventory ratio and the foreign source intangible ratio cannot exceed one.[9] Second, if the foreign source gross income attributable to inventory or the foreign gross ordinary income is not positive, then respectively the foreign source inventory ratio or the foreign source intangible ratio is zero. Third, if the foreign source gross income attributable to inventory is positive, but the total gross income attributable to inventory is not positive, or if the foreign gross ordinary income is positive, but the total gross ordinary income is not positive, then respectively the foreign source inventory ratio or the foreign source intangible ratio is one.[10]
Reg. §1.864(c)(8)-1(c)(2)(ii)(D) provides a two-part approach for determining the foreign source portion of deemed sale gain and loss attributable to depreciable personal property: The first part applies a recapture principle to the extent of depreciation adjustments taken with respect to the property, and the second part focuses on where the property is located to the extent the property has deemed sale gain in excess of its depreciation adjustments or if the property has deemed sale loss.
Reg. §1.864(c)(8)-1(c)(2)(ii)(D)(1) applies a recapture principle by providing that the deemed sale of depreciable personal property (as defined in Section 865(c)(4)(A)), or the deemed sale of an amortizable intangible (as defined in Section 865(d)(2)), will not be treated as attributable to an office or other fixed place of business maintained by the partnership in the United States to the extent the deemed sale gain is treated as sourced outside the United States after applying Section 865(c)(1) at the time of the deemed sale. In contrast to the other sourcing rules that could apply to assets held by the partnership on the date of the deemed sale, the recapture rule provided in Section 865(c)(1) can be applied with certainty at the time of the deemed sale because it is based on data that is available at the time of the deemed sale.
For deemed sale gain in excess of the depreciation adjustments with respect to depreciable personal property (other than an amortizable intangible), or for deemed sale loss from depreciable personal property (other than an amortizable intangible), §1.864(c)(8)-1(c)(2)(ii)(D)(2) provides that the relevant sourcing determination is made based on where the property is located. Reg. §1.864(c)(8)-1(c)(2)(ii)(D)(2) sources the excess gain or loss attributable to depreciable personal property based on the location of the property.
Reg. §1.864(c)(8)-1(c)(2)(ii)(E) provides a material change in circumstances rule for inventory and intangibles. If this rule applies, the foreign source portion of deemed sale gain or loss attributable to inventory property or intangibles may be determined by applying the relevant rule of §1.864(c)(8)-1(c)(2)(ii)(B) or (C) by reference to a modified look-back period. The application of §1.864(c)(8)-1(c)(2)(ii)(E), therefore, is limited to situations in which a material change in circumstances causes the look-back rule provided in §1.864(c)(8)-1(c)(2)(ii)(B), or the look-back rule provided in §1.864(c)(8)-1(c)(2)(ii)(C), to reach an inappropriate sourcing result; that is, a sourcing result that is materially different from the sourcing result that would occur if the applicable look-back period began on the date on which the material change in circumstance occurred and ended on the last day of the partnership’s taxable year immediately preceding the year in which the deemed sale occurs (the modified look-back period). If the material change in circumstances rule applies, the applicable sourcing rule for inventory or intangibles may be applied by reference to the modified look-back period.[11] The determination of whether a sourcing result is materially different is determined by comparing the foreign source inventory ratio or foreign source intangible ratio provided in §1.864(c)(8)-1(c)(2)(ii)(B) or (C) (as applicable) with the foreign source inventory ratio or foreign source intangible ratio if that ratio were determined by reference to the modified look-back period. The sourcing result is not materially different unless the percentage point difference between the two ratios described in the preceding sentence is at least 30 percentage points.[12]
In the case of foreign partners entitled to treaty benefits, the final regulations retain the general rule that prevents taxation of gain on assets that do not form part of a permanent establishment, but also address certain gains that may be taxed without regard to whether there is a permanent establishment (for example, gains from the disposition of certain U.S. real property interests). The final regulations also modify the structure of proposed §1.864(c)(8)-1(f) by consolidating proposed §1.864(c)(8)-1(f)(1) through (3) into a single paragraph and make three additional changes.
First, §1.864(c)(8)-1(f) clarifies that a foreign transferor is eligible for benefits under an income tax treaty only if the transferor meets the requirements of a limitation on benefits article, if any, in the treaty between the jurisdiction in which the foreign transferor is resident and the United States.
Second, §1.864(c)(8)-1(f) modifies proposed §1.864(c)(8)-1(f)(2), which stated that “[t]reaty provisions applicable to gains from the alienation of property forming part of a permanent establishment, including gains from the alienation of a permanent establishment in the United States, apply to the transfer by a foreign transferor of an interest in a partnership with a permanent establishment in the United States.” The final regulations clarify that a gains article that permits the taxation of gain from the alienation of property forming part of a permanent establishment or fixed place of business in the United States also permits the taxation of gain from the alienation of a partnership interest, to the extent the partnership’s assets deemed sold under Section 864(c)(8) form a part of the U.S. permanent establishment or fixed place of business of the partnership.
Finally, §1.864(c)(8)-1(f) adds a rule coordinating these regulations with treaty provisions governing the disposition of United States real property interests, which allow the United States to tax gain derived from the disposition of the United States real property interest without regard to whether the U.S. real property interest forms a part of a partnership’s permanent establishment or fixed place of business in the United States. Under this coordination rule, if, after applying treaty benefits in paragraph (c)(3) of this section, the only gains or losses that would be taken into account are gains or losses attributable to United States real property interests, the foreign transferor determines its effectively connected gain and effectively connected loss pursuant to Section 897 and not under Section 864(c)(8).
The final regulations provide that a foreign transferor’s distributive share of deemed sale EC gain or loss does not include any amount that is excluded from the foreign transferor’s gross income or otherwise exempt from U.S. federal income tax by reason of an applicable provision of the Code.[13] For this purpose, the final regulations refer to Sections 864(b)(2), 872(b), and 883 as examples.[14]
Similarly, §1.864(c)(8)-1(c)(3) is modified to provide that a foreign transferor’s distributive share of deemed sale EC gain or deemed sale EC loss does not include any amount to which an exception under Section 897 applies, such as Section 897(k) or Section 897(l), provided that amount is not otherwise treated as effectively connected income under a provision of the Code.
The final regulations clarify the interaction between the Section 897 coordination rule and the nonrecognition provision described in §1.864(c)(8)-1(b)(2)(ii). Specifically, §1.864(c)(8)-1(d) provides that any transfer of an interest in a partnership as part of a nonrecognition transaction will not be subject to Section 864(c)(8) to the extent that the gain or loss on the transfer is not recognized; instead, if the partnership owns one or more United States real property interests, Section 897(g) and the regulations thereunder will apply with respect to the unrecognized gain or loss.
Applicability Dates
The final regulations generally apply to transfers occurring on or after December 26, 2018. Transfers occurring on or after November 27, 2017, but before December 26, 2018, are subject to Section 864(c)(8). In addition, the final regulations apply to amounts taken into account on or after December 26, 2018, pursuant to an installment sale (as defined in Section 453(b)) occurring on or after November 27, 2017, and before December 26, 2018.[15]
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