Proposed regulations dealing with the sale of a partnership have been issued by the IRS (REG-113604-18) to implement changes made by Congress in the Tax Cuts and Jobs Act. Specifically, TCJA made the following changes to deal with foreign holders of partnership interests:

• Requiring foreign partners to treat the sale of a partnership interest as “effectively connected” with a U.S. trade or business if a sale of the partnership’s assets would have created such effectively connected income (overturning the result in Grecian Mining v. Commissioner, 149 TC No. 3)[1]; and

• Requiring the buyer of a partnership interest to withhold 10% of the purchase price unless the buyer certifies the buyer is not a foreign person.[2]

These proposed regulations deal only with the first category of transactions--rules on withholding are not in this of regulations, though the preamble notes that Treasury and the IRS “intend to issue guidance under section 1446(f) expeditiously.”

The proposed regulations begin by dealing with new IRC §864(c)(8) with rules on how the foreign interest holder determines the effectively connected gain or loss. That provision is outlined in the preamble:

 Section 864(c)(8)(A) provides that gain or loss of a foreign transferor from the transfer of an interest, owned directly or indirectly, in a partnership that is engaged in any trade or business within the United States is treated as effectively connected gain or loss 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 transferor’s distributive share of gain or loss that would have been effectively connected gain or loss if the partnership had sold all of its assets at fair market value. The proposed regulations set forth rules for determining gain or loss described in section 864(c)(8)(A) and the limitation described in section 864(c)(8)(B), each of which is discussed in this section I of this Explanation of Provisions.

As the preamble describes the issue:

To determine the amount of gain or loss described in section 864(c)(8)(A), generally, the proposed regulations require that a foreign transferor first determine its gain or loss on the transfer of a partnership interest (“outside gain” and “outside loss”). For this purpose, the proposed regulations provide that outside gain or loss is determined under all relevant provisions of the Code and the regulations thereunder. As described in section I.A.1 of this Explanation of Provisions, a foreign transferor may recognize capital gain or loss (“outside capital gain” or “outside capital loss”) and ordinary gain or loss (“outside ordinary gain” or “outside ordinary loss”) on the transfer of its partnership interest and must separately apply section 864(c)(8) with respect to its capital gain or loss and its ordinary gain or loss.

IRC §§741 and 751 govern gain and loss calculations generally when a taxpayer sells an interest in a partnership.

In general, the proposed regulations provide that a foreign transferor must determine the portion of its capital gain or loss, and the portion of its ordinary income or loss from section 751 property, that must each be characterized as effectively connected gain or loss under section 864(c)(8). See proposed §1.864(c)(8)-1(b). As provided in section 864(c)(8)(A) and further described in section I.B of this Explanation of Provisions, the proposed regulations provide that a foreign partner’s effectively connected gain or loss will not exceed its outside gain or loss on the sale of the interest as determined under sections 741 and 751 and the regulations thereunder. Thus, the amount of gain or loss determined under section 741 (before application of section 751) is not a limitation on the amount of gain or loss characterized as effectively connected with the conduct of a trade or business within the United States under the proposed regulations.

The preamble indicates that although IRC §864(c)(8)(E) authorizes the IRS to issue regulations to deal with the impact of nonrecognition transactions with this provision, such regulations are not included in this set of proposed regulations.  Rather, the preamble continues:

The Treasury Department and the IRS recognize, however, that certain nonrecognition transactions may have the effect of reducing gain or loss that would be taken into account for U.S. federal income tax purposes. For example, if a partnership that conducts a trade or business within the United States owns property not subject to tax under section 871(b) or 882(a) in the hands of a foreign partner, the partnership may distribute that property to the foreign partner rather than a U.S. partner. The Treasury Department and the IRS continue to consider, and comments are requested regarding, whether other Code provisions adequately address transactions that rely on section 731 distributions to reduce the scope of assets subject to U.S. federal income taxation, and may propose rules addressing these types of transactions.

The preamble notes that once a taxpayer has determined the outside gain or loss, the taxpayer must then determine the limitation found in IRC §864(c)(8)(B) by determining the following three amounts:

• With respect to each asset held by the partnership, the amount of gain or loss that the partnership would recognize in connection with a deemed sale to an unrelated party in a fully taxable transaction for cash equal to the asset’s fair market value immediately before the partner’s transfer of its partnership interest;

• The amount of that gain or loss that would be treated as effectively connected gain or loss (“deemed sale EC gain” and “deemed sale EC loss”); and

• The foreign transferor’s distributive share of the ordinary and capital components of any deemed sale EC gain and deemed sale EC loss.

The preamble then describes terms used for items determined by these calculations:

The proposed regulations refer to the separate sums of the foreign transferor’s distributive shares of the ordinary and capital components of deemed sale EC gain and deemed sale EC loss items for all assets, determined at the level of the foreign transferor, as “aggregate deemed sale EC capital gain,” “aggregate deemed sale EC capital loss,” “aggregate deemed sale EC ordinary gain,” and “aggregate deemed sale EC ordinary loss.”

The preamble next describes how to apply the limitation:

After each of these aggregate amounts is determined, the proposed regulations implement the limitation described in section 864(c)(8)(B), generally, by comparing the foreign transferor’s outside gain or loss amounts with the relevant aggregate deemed sale EC gain or loss. This determination is made separately with respect to capital gain or capital loss and gain or loss treated as ordinary income or ordinary loss. Thus, for example, a foreign transferor would compare its outside capital gain to its aggregate deemed sale EC capital gain, treating the former as effectively connected gain only to the extent it does not exceed the latter. See proposed §1.864(c)(8)-1(b)(3).

The rule proposed in the regulations generally turn any deemed sale gain or loss as coming from sources inside the United States.  However, the regulations provide an exception:

To prevent this rule from potentially converting 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, the proposed regulations provide that gain or loss from the deemed sale of a partnership asset is not treated as effectively connected gain or loss if (1) no income or gain previously produced by the asset was taxable as effectively connected with the conduct of a trade or business within the United States by the partnership (or a predecessor of the partnership) during the ten-year period ending on the date of the transfer, and (2) the asset was not used, or held for use, in the conduct of a trade or business within the United States by the partnership (or a predecessor of the partnership) during the ten-year period ending on the date of transfer. See proposed §1.864(c)(8)-1(c)(2)(ii).

The proposed regulations provide the following rules for determining a partner’s share of the deemed sale EC gain and deemed sale EC loss:

The proposed regulations provide that a partner’s distributive share of gain or loss from the deemed sale is determined under all applicable Code sections (including section 704), taking into account allocations of tax items applying the principles of section 704(c), including any remedial allocations under §1.704-3(d), and any section 743 basis adjustment pursuant to §1.743-1(j)(3). The Treasury Department and IRS propose this approach because applying section 704 more closely ties the results of the deemed sale with regard to the selling foreign partner to the economic results of an actual sale, as compared (for example) to an approach that did not consider special allocations or considered only a partner’s share of ordinary business income, which would distort the economic agreement among the partners. See proposed §1.864(c)(8)-1(c)(3)(i).

However, the IRS is concerned whether such use of IRC §704 could allow for evasion of this rule and ask for comments on the issue:

The Treasury Department and the IRS are considering whether section 704 and the regulations thereunder adequately prevent the avoidance of the purposes of section 864(c)(8) through allocations of effectively connected gain or loss to specific partners. For example, immediately before a foreign transferor sells its interest in a partnership, adjustments could be made to partnership allocations that would result in the foreign transferor recognizing less effectively connected gain from the deemed sale by the partnership. While statutory and regulatory provisions, as well as judicial doctrines, may limit the extent to which inappropriate results may be obtained in that transaction or similar transactions, the Treasury Department and the IRS are considering whether additional guidance is necessary to prevent abuse.

IRC §897(g) provides for effectively connected treatment for real property held by a partnership, a provision that existed in the IRC before TCJA.  To coordinate the new rule with that prior provision, the regulations provide the following:

…[W]hen a partnership holds United States real property interests and is also subject to section 864(c)(8) because it is engaged in the conduct of a trade or business within the United States without regard to section 897, the amount of the foreign transferor’s effectively connected gain or loss will be determined under section 864(c)(8) and not under section 897(g). Therefore, the reduction called for by section 864(c)(8)(C) is not necessary. See proposed §1.864(c)(8)-1(d).

The regulations contain provisions to force tiered partnership structures to take the deemed sale rules into account both when a partner disposes of an interest in an upper tier partnership and when an upper tier partnership with foreign partners transfers an interest in a lower tier partnership that is conducting a trade or business.

[1] IRC §864(c)(8)

[2] IRC §1446(f)