Final Regulations: Foreign Person’s Sale/Exchange of Partnership Interest
By Ragini Subramanian, Manager, Tax & Business Services
In December 2018, proposed regulations were issued related to new Internal Revenue Code Section 864(c)(8). Under this new code section, a foreign person’s gain or loss on the sale or exchange of a partnership interest in a trade or business in the U.S. is recognized to the extent such gain or loss would be considered effectively connected to the partnership, had the partnership sold all of its assets at fair market value. A foreign person is defined as a foreign individual or a foreign corporation.
On September 23, 2020, the IRS released final regulations which retained the basic approach of the proposed regulations.
- The proposed regulations in 2018 provided a three-step approach to arrive at a foreign person’s taxable gain or loss:
Step 1: On the date of the transfer of a partnership interest by the foreign transferor, the partnership is deemed to have sold all its assets at fair market value and derived deemed gain or loss for each asset deemed sold on such date.
Step 2: The partnership next determines if the gain or loss associated with each asset can be treated as effectively connected with the U.S. trade or business (“USEC”). To simplify application of various sourcing rules, the proposed regulations suggested that if the partnership maintained an office or fixed place of business in the U.S., all gains or loss from deemed sale of assets attributed to such office or fixed place of business was an effectively connected gain or loss (“office attribution rule”).
Step 3: Finally, the foreign transferor’s distributive share of the effectively connected gain or loss is determined based on the outcome of Step 2 and other parameters.
- Note that the computation does not include gain or loss associated with the sale or exchange of a U.S. real property interest.
The IRS released final regulations retaining the basic approach of the proposed regulations with certain revisions:
1. Applicability date
The final regulations apply to transfers occurring on or after December 26, 2018. They also apply to amounts includible in income after December 26, 2018, pursuant to an installment sale occurring after November 27, 2017, and before December 26, 2018.
2. Sourcing rules
- Final regulations modified sourcing rules to determine if the gain or loss on a deemed sale under Step 2 above is USEC.
- Only the gain or loss from the deemed sale of personal property (as opposed to all property) held by an office or fixed place of business of the partnership in the U.S. is treated as USEC.
- If the asset is an inventory, intangible, or depreciable personal property, and is held by an office or fixed place of business of the partnership in the U.S., the characteristic of gain or loss as USEC is determined by applying special sourcing rules as provided in the final regulations.
- If the partnership does not have an office or maintain a place of business in the U.S., or the asset being deemed sold is neither personal property nor inventory nor intangible property, general sourcing rules of the U.S. tax code should be used to determine USEC character of the gain or loss.
3. Ten-year exception
The final regulations retain the 10-year exception in determining whether the gain or loss is USEC. The 10-year period is shortened to the lesser of the 10-year period ending on the date of transfer or the period during which the partnership held the asset, for a partnership that has not existed for at least 10 years, or for a partnership that has not held an asset for at least 10 years. Conversely, the final regulations included in the 10-year period the period during which the asset generated effectively connected income or gain for the foreign transferor or the asset was used in the conduct of a U.S. trade or business by the foreign partner.
4. Treaty coordination
The foreign transferor can seek treaty benefits under the applicable U.S. income tax treaty to exempt gain or loss includible in income.
5. Clarification of coordination rules
The final regulations clarify that any transfer of interest in a partnership as part of any non-recognition transaction under the tax code will not be subject to Code Sec. 864(c)(8). In addition, if the partnership owns U.S. real property interest, gain or loss recognition, if any, will be subject to the gain recognition provisions related to U.S. real property interest and not this section.
6. Partner-specific exclusions and exceptions
The final regulations clarify that the foreign transferor’s distributive share of taxable gain or loss does not include any amount excludible from the foreign transferor’s gross income or otherwise exempt from U.S. federal income tax.