On December 26, 2018, the IRS and Treasury issued proposed regulations under Section 864(c)(8) of the tax code, which generally subjects foreigners to tax on a sale of equity in a partnership that is engaged in a U.S. trade or business.

Section 864(c)(8) was enacted as part of the Tax Cuts and Jobs Act.  The tax imposed under Section 864(c)(8) is enforced, in part, by Section 1446(f), which generally requires a purchaser of partnership equity from a foreigner to withhold 10% of the purchase price if any portion of the gain would be treated as "effectively connected" with a U.S. trade or business.  The IRS has indicated that it intends to issue regulations under Section 1446(f) in the future.  

Key items addressed in the proposed regulations include:

• General Principles for Determining Effectively Connected Gain or Loss. A foreign transferor must apply general tax law, including subchapter K rules, to determine the amount and character of any gain or loss on the transfer of its partnership interest. Accordingly, a foreign transferor may have capital gain or loss (under Section 741)  or ordinary gain or loss (under Section 751), and each may be characterized as effectively connected gain or loss  under Section 864(c)(8). General tax non-recognition provisions under the Code may be applied to eliminate or reduce the amount of gain or loss that would otherwise be taken into account.
• Steps for Computing the Amount of Effectively Connected Gain or Loss. Three steps are used to compute the amount of effectively connected gain or loss:

            Step 1. Determine the amount of gain or loss that the partnership would recognize with respect to each of its assets upon a deemed taxable sale for cash to an unrelated person on the date of the transfer of the partnership interest.

            Step 2. With respect to each asset sold, determine the gain or loss from the deemed sale that would be effectively connected gain or loss (generally applying Section 864 principles).

            Step 3. Determine the partner’s distributive share of the deemed effectively connected gain or loss under step 2. General partnership principles such as allocation provisions under Section 704(c) and basis adjustments under Section 743 continue to apply.

Once these three amounts are determined, the proposed regulations limit the transferor partner's effectively connected outside gain or loss amounts to such partner's distributive share of deemed gain or loss under step 3. If a foreign partner transfers only part of its partnership interest, then the partner's distributive share of deemed gain or loss taken into account is limited to the proportionate amount attributable to the foreign partner's partnership interest that was transferred.

• Coordination with Section 897(g). The FIRPTA rules contained in Section 897(g) provide that the amount realized by a foreign person upon the sale, exchange or other disposition of a partnership interest that is attributable to U.S. real property interests is subject to U.S. tax. Since the FIRPTA rules generally provide the same result for U.S. real property interests as Section 864(c)(8) provides for property used in a trade or business, Section 864(c)(8)(C) reduces the amount of gain under Section 864(c)(8) by the amount taxed under Section 897. The proposed regulations, however, reverse this statutory ordering, instead providing that when a partnership holds U.S. real property interests and is subject to Section 864(c)(8) because it is in any event engaged in a US trade or business, then the amount of gain or loss is determined under 864(c)(8) and not under Section 897(g).
• Tiered Partnerships. If a foreign partner transfers an interest in an upper-tier partnership that owns one or more partnerships that are engaged in a U.S. trade or business, then each partnership is treated as selling its assets in accordance with the provisions of the proposed regulations, beginning with the lowest-tier partnership and going up the chain. Similar principles apply to a foreign person that owns an interest in an upper-tier partnership that sells an interest in a lower-tier partnership that is engaged in a U.S. trade or business.
• Treaties. In general, the permanent establishment of a partnership in the U.S. is considered a permanent establishment of the partners of that partnership. Under the proposed regulations, a disposition by a foreign partner of a partnership interest will be treated as a disposition of its permanent establishment.  Accordingly, for purposes of any “Gains” article of a tax treaty that preserves the U.S. taxing jurisdiction over the permanent establishment, Section 864(c)(8) principles will apply.
• Anti-Stuffing Rule. The proposed regulations implement an anti-stuffing rule whereby a transfer of property to a partnership by a foreign transferor (or related person) will be disregarded if a principal purpose of such transfer is to reduce the amount of effectively connected gain or to increase the amount of effectively connected loss under Section 864(c)(8) or Section 897.
• Applicability. The proposed regulations apply to transfers occurring on or after November 27, 2017.