Prior to 2017, the IRS took the position (formally stated in Rev. Rul. 91-32) that a foreign person who sells an interest in a partnership that carries on a U.S. trade or business must treat some or all of the gain from that sale as effectively connected with a U.S. trade or business (ECI), and therefore subject to the U.S. net basis income tax. In 2017, however, the Tax Court disagreed with the IRS in Grecian Magnesite Mining v. Comissioner, 149 T.C. 3 (2017), holding that gain on the sale of a partnership interest is not ECI, even if the partnership is engaged in a U.S. trade or business.
This favorable treatment did not last long, however, as Congress exercised its legislative authority to write the Rev. Rul. 91-32 into law as part of the Tax Cuts and Jobs Act of 2017, as new section 864(c)(8). The IRS has now issued proposed regulations, which provide additional guidance around this new statutory rule.
The proposed regulations provide a three-step process for calculating the amount of gain to be treated as ECI under Section 864(c)(8):
- Determine the selling partner’s tax gain or loss under existing tax law, separating out ordinary and capital components applying the general rules that apply to the sale of partnership interests
- Determine the partner’s allocable share of capital gain and ordinary income (or loss, as appropriate) that would be treated as ECI if the partnership sold all of its assets at fair market value, taking into account any special adjustments normally required under generally applicable principles that apply to partnerships
- Separately for ordinary and capital components, treat the lesser of the amount determined in step one and step two as ECI
Note that, because of the separate computation of capital and ordinary components, this can result in a situation where a foreign partner may have to pay tax on gain treated as ECI, even if the overall sale transaction results in a loss.
In addition,the proposed regulations also provide several coordination rules. For example, the proposed regulations provide that any gain on the disposition of a partnership interest attributable to a U.S. real property interest is not also taken into account under the rules governing sales of U.S. real property interests (the FIRPTA rules). The proposed regulations also address taxpayers resident in jurisdictions resident in countries that have tax treaties with the U.S. and would allow taxpayers to claim benefits under those treaties, under certain circumstances
Section 1446(f), enacted at the same time as Section 864(c)(8), provides a collection mechanism for the tax imposed by Section 864(c)(8) by requiring the purchaser of a partnership interest from a foreign person to withhold 10 percent of the amount realized by the seller on the transaction, if Section 864(c)(8) would apply to the transaction. These proposed regulations do not provide futher guidance on the application of Section 1446(f), but do indicate that further guidance is forthcoming. In the meantime, taxpayers can continue to rely on existing Notice 2018-29 in complying with their withholding requirements under Section 1446(f) (reference prior alert).
These regulations, if finalized by June 22, 2019, would be effective retroactively to Nov. 27, 2017—the effective date of the statute itself. If finalized later than that date, would be effective on the date of finalization.