On September 21, 2020, the IRS finalized regulations (the “Final Regulations”) under section 864(c)(8) of the Internal Revenue Code (the “Code”). The Final Regulations generally impact foreign partners in partnerships engaged in a U.S. trade or business and generally retain the approach of proposed regulations that were issued on December 20, 2018 (REG-113604-08) (the “Proposed Regulations”), with certain revisions. The Final Regulations provide rules for determining the amount of gain or loss treated as effectively connected income (“ECI”) under section 864(c)(8), and coordinate the application of such rules with other relevant sections of the Code.
Section 864(c)(8) was added to the Code by the Tax Cuts and Jobs Act, Public Law 115-97 (2017), which was enacted on December 22, 2017. Section 864(c)(8)(A) provides that gain or loss of a foreign partner from the sale, exchange, or other disposition of an interest in a partnership that is engaged in a trade or business within the United States is treated as effectively connected to the extent such gain or loss does not exceed the amount determined under section 864(c)(8)(B). In general, section 864(c)(8)(B) limits the amount of effectively connected gain or loss to the portion of the foreign partner’s distributive share that would have been effectively connected if the partnership had sold all of its assets at fair market value (the “Deemed Sale Limitation”).
The Proposed Regulations provided guidance on the calculation of the Deemed Sale Limitation that simplified administration at the expense of non-U.S. partners. Specifically, the Proposed Regulations treated all deemed sale gain and loss of the partnership as U.S. source income unless during the ten-year period ending on the date of transfer, the partnership asset in question (i) produced no income or gain that was ECI and (ii) had not been used, or held for use, in the conduct of a U.S. trade or business by the partnership (the “Lookback Exception”).
The Proposed Regulations would likely cause a non-U.S. partner transferring its partnership interest to recognize more ECI than if the partnership itself had sold all of its assets. As discussed further below, the Final Regulations provide helpful clarifications and taxpayer friendly revisions to the approach taken by the Proposed Regulations with reference to the computation of the Deemed Sale Limitation.
Deemed Sale Calculation Revisions
The Final Regulations clarify that the general rule in the Proposed Regulations that sourced all deemed sale gain or loss to the U.S., applies only for purposes of personal property held by the partnership on the date of the deemed sale. In addition, the Final Regulations clarify the sourcing treatment of specific categories of partnership assets in the deemed sale computation including inventory, intangible and depreciable personal property. While these changes are generally expected to be taxpayer friendly in the context of a sale by a non-U.S. partner of a partnership interest and are expected to result in a closer approximation to the ECI that would be recognized by a non-U.S. partner on a sale by a partnership of all of its assets than was the case under the Proposed Regulations, these rules are complex in their application and will require access to partnership asset level information that may be difficult to obtain. Lastly, the Final Regulations expand the Lookback Exception by modifying the relevant testing period to account for a partnership that has not existed for at least ten years, or that has not held an asset for at least ten years. Specifically, the Final Regulations shorten the relevant testing period to the lesser of the ten-year period ending on the date of the partnership interest transfer or the period during which the partnership held any such asset.
The Final Regulations clarify that the general rule provided in the Proposed Regulations that sourced all deemed sale gain or loss to the U.S., was not intended to apply in the treaty context unless the partnership had a permanent establishment in the U.S. at the time of the transfer. As a result of this rule, the transfer of an interest in a partnership that does not have a U.S. permanent establishment, and the transfer of partnership assets that do not form part of a U.S. permanent establishment, are generally not taken into account in determining gain or loss under section 864(c)(8). However, the Final Regulations add a rule, which taxes gain derived from the disposition of a U.S. real property interest without regard to whether the real property interest forms a part of a partnership’s U.S. permanent establishment.
Partner-specific exclusions and exceptions
The Final Regulations provide that a foreign partner’s distributive share of deemed sale gain or loss does not include any amount that is excluded from the foreign partner’s gross income or otherwise exempt from U.S. Federal income tax by reason of an applicable provision of the Code.
Clarification of section 897 coordination rule with respect to nonrecognition provisions
The Final Regulations clarify that any nonrecognition transfer of an interest in a partnership will not be subject to section 864(c)(8). Instead, if the partnership owns one or more U.S. real property interests, section 897(g) will apply with respect to the unrecognized gain or loss potentially causing recognition of the FMV of the U.S. real property interest.
The Final Regulations generally apply to transfers occurring on or after December 26, 2018. Taxpayers should be mindful that the relevant tax rules are complex and special care should be taken to understand both the benefits and collateral consequences that can arise from the application of these tax rules.