Proposed regulation provide guidance under Code Sec. 864(c)(8) on the transfer by foreign persons of interests in a partnership that is engaged in the conduct of a trade or business in the United States. Rules for the treatment of gain or loss on these transfers as income effectively connected to a trade or business within the United States were enacted by the Tax Cuts and Jobs Act (TCJA) (P.L. 115-97). The proposed regulations do not address the corresponding withholding provisions in Code Sec. 1446(f), also enacted by the TCJA.
Controversy over Treatment of Foreign Person’s Transfer of Partnership Interest
The TCJA settled a controversy over the tax treatment of gain or loss on a foreign partner’s sale or exchange of a partnership interest, where the partnership is engaged in a U.S. trade or business. Rev. Rul. 91-32, 1991-1 CB 107 stated that the partnership’s property located in the United States and used in the trade or business in the United States was the basis for determining how much of the income from the sale or exchange was effectively connected income, taxed at ordinary rates.
In 2017, the Tax Court held in Grecian Magnesite Mining, Dec. 60,968, that gain or loss on the sale or exchange by a foreign partner of a partnership interest is foreign source gain or loss based on the residence of the selling partner. Under this rule, the gain or loss would not be treated as effectively connected income.
The TCJA enacted Code Sec. 864(c)(8) to overturn the Tax Court’s decision. Under the provision, gain or loss of a foreign transferor upon the transfer of a partnership interest is treated as effectively connected gain or loss to the extent the transferor would have effectively connected gain or loss if the partnership sold all of the assets at fair market value on the date of the sale or exchange (deemed sale). Code Sec. 1446(f) imposed a 10 percent withholding tax on the amount realized on the disposition.
Gain or Loss
The proposed regulations provide rules for determining the treatment of gain or loss on the transfer of a partnership interest as effectively connected gain or loss. The foreign transferor must first determine its gain or loss on the transfer of the partnership interest (outside gain or outside loss). The rules of Code Sec. 864(c)(8) are applied separately to outside capital gain loss and ordinary gain or loss. Applicable law, including subchapter K, determines the amount and character of outside gain or loss on the transfer of a partnership interest.
The proposed regulations provide that gain or loss on the transfer of the partnership interest that is taxed as effectively connected gain or loss is limited to gain or loss recognized under the Code. The proposed regulations do not provide special rules for nonrecognition transactions.
Deemed Sale Gain or Loss
Once the outside gain or loss is determined, the following three amounts must be determined by the foreign transferor to derive the limitation based on the deemed sale, against which the outside gain or loss is compared:
– the amount of gain or loss on a deemed sale to an unrelated party;
– the portion of the gain or loss that would be treated as effectively connected gain or loss; and
– the foreign transferor’s distributive share of the ordinary and capital components of the effectively connected gain and deemed sale effectively connected loss.
The proposed regulations apply Code Sec. 864 and its regulations in determining whether gain or loss from the asset sale is effectively connected gain or loss. The deemed asset sale is attributable to an office or fixed place of business in the United States maintained by the partnership. The deemed sale gain or loss would generally be treated as U.S. source. The proposed regulations provide rules to prevent the conversion of gain or loss from assets with no connection to the partnership’s trade or business within the United States into effectively connected gain or loss.
Coordination rules, tiered-partnerships and treaties
The provision in Code Sec. 864(c)(8) are non-exclusive and do not prevent a portion of the gain or loss from being treated as effectively connected gain or loss under other Code provisions. Special rules coordinate the rules of Code Sec. 864(c)(8) and Code Sec. 897 relating to investments in U.S. real property.
The proposed regulations also address tiered-partnerships, consistent with section 12 of Notice 2018-29, when there is a transfer of an interest in an upper-tier partnership, that owns directly or indirectly, an interest in a lower-tier partnership engaged in a trade or business within the United States.
The proposed regulations treat the disposition of a foreign partner’s interest in a partnership as a disposition of all or a portion of the partner’s permanent establishment. To the extent the partnership’s form part of the foreign partner’s permanent establishment in the United States, an income tax treaty gains article would preserve the United States’ taxing jurisdiction over the gain.
The rules apply to transfers occurring on or after November 27, 2017, the effective date of Code Sec. 864(c)(8).
Proposed Regulations, NPRM REG-113604-18
Code Sec. 864
CCH Reference – 2018FED ¶27,188G
Code Sec. 897
CCH Reference – 2018FED ¶27,707G
CCH Reference – 2018FED ¶27,708B
Tax Research Consultant
CCH Reference – TRC INTLIN: 3,104