A Feast for the Tax Lawyers: The Proposed §864(c)(8) Regulations

Over the holiday season, the US Treasury Department released the Proposed Regulations to IRC §864(c)(8), governing the sale, transfer or other disposition of certain partnership interests (mainly, private equity fund investments) by non-resident aliens (NRAs). The Proposed Regulations resolve the inconsistencies between the statute and existing US tax principles by incorporating heaps of existing federal tax provisions by reference. This deference molds the new statute to existing rules covering partnership interest sales by NRAs, but, as a result, this topic demands exhaustive prior exposure to multiple areas of US federal tax law. Alone, Example Three of the illustrative examples at the end of the Proposed Regulations implicates multiple tricky concepts from the partnership rules under subchapter K, such as the scope of §704 allocation discretion, the calculation of outside basis and the recharacterization of sales proceeds per §751, plus various international and corporate tax concepts, such as ECI, USRPIs and sourcing rules. Moreover, these concepts merely serve as the background landscape to the Proposed §864(c)(8) Regulations, which then apply their own special mustard to the topic. In sum, those with a taste for the diverse provisions referenced in this regulatory hot pot, will delight in savoring each one. The rest though may feel quite queasy when a single reference (even one from inside a parenthetical) leads to a hundred pages of extra regulations.
 
Content of Proposed §864(c)(8) Regulations
For those with the stomach to digest all these background prerequisites, the Proposed Regulations effectively settle many statutory ambiguities attendant to the sale, transfer or other disposition by NRAs of partnership interests earning potential ECI. Foremost, it informs the taxpayer how to calculate the amounts of gain or loss taxable as ECI. First, it instructs the NRA taxpayer to calculate effectively connected gain or loss and to characterize portions of the gain or loss as capital gain or ordinary income under the prevailing principles of subchapter K. Then, it sets forth a three-step process in order to cap this amount: Calculate the amount of gain or loss by means of a hypothetical sale scenario of all the partnership’s assets; determine the portion of such amounts qualifying as ECI; and identify the distributive share of such ECI attributable to the NRA transferor (consistent with §704). These two calculations, heavily reliant on themes from subchapter K, are the essence of the Proposed Regulations.
 
However, other topics are addressed as well in an effort to ensure that the core aim of taxation of such interests as ECI is reached, but not overreached. In order to accomplish this purpose, the regulations contemplate the following items:

• Multi-tier structures and the calculation of the taxable amount of ECI from sales of interests in the uppermost partnerships (e.g. a funds of funds’ scenario), which, regrettably, offers no de minimis relief and depends on information that may not be readily accessible;
• The treatment of transactions that permit deferred taxation (i.e. non-recognition events);
• The interaction of §864(c)(8) with §897, governing the dispositions of US Real Property Interests (USRPIs), the proceeds from which are also treated as ECI for NRA sellers;
• The application of §864(c)(8) where the activity falls under a tax treaty, rather than under the Treasury Regulations (which may, if taken to logical ends, result in treaty disputes and/or double taxation);
• The treatment of §707 distributions in excess of an NRA partner’s outside basis in the partnership;
• A sui generis sourcing rule, applicable solely to this provision and positing the anomaly in which non-US source income is characterized as ECI; and
• Anti-abuse rules (called “anti-stuffing” rules here), which seek to prevent any re-structuring of partnership allocations in order to reduce ECI exposure for NRA partners.

 
Implications for Swiss Taxpayers, PE Funds and other Swiss Financial Institutions
These Proposed Regulations set out the method of calculation for taxable income from the sale or other disposition of qualifying partnership interests by NRAs. Such information is crucial to NRA taxpayers who must calculate their taxable income following the sale of such an interest. Furthermore, private equity funds ought to rely on these Proposed Regulations in order to determine which information their NRA investors will expect to receive in order to calculate their §864(c)(8) tax liabilities.
 
But there are other party-goers at this banquet and several corollary topics remain unaddressed, two of which will play significant roles for Swiss private equity funds and financial institution, as follows:

• The §1446(f) withholding regulations will set the scope and application of the withholding obligations, which fall primarily on the buyer of an in-scope partnership interest and, residually, on the partnership itself (please find my blog on the current state of the withholding rules at http://millentaxandlegal.ch/blogs/private-equity-withholding-regulations-released). Once final, these regulations will determine the withholding and reporting mechanisms that private equity fund managers will need to establish. The  §864(c)(8) Proposed Regulations aid in that determination by calculating the baseline value of the total taxable amount, but complicate it materially in other ways and, thus, the final withholding regulations may set out some further limitations.
• The treatment of the sale, transfer or other disposition of interests in qualifying Publicly-Traded Partnerships (PTPs), which have been necessarily severed from their non-PTP brethren. This treatment will determine whether custodial banks can comfortably fold such PTP interests into their current QI positions or need to consider alternatives, including potentially forced divestment of qualifying PTP interests by their account holders.

 
Through the release of the Proposed §864(c)(8) Regulations, the regime governing the sale or other disposition of certain partnership interests by NRAs advances, but it does so fitfully and through resort to daunting preparatory knowledge. The incorporation of so many provisions from other sections of the US tax code and regulations, however, while helping ensure consistent flavor, may deter newcomers from taking a first bite.
 
Timelines and Other Sources of Information
As Proposed Regulations, these rules are not in force until released in final form. If finalized by 22 June 2019 the §864(c)(8) Regulations will be retroactive to 27 November 2017 (or, if not finalized until after 22 June 2019, to 20 December 2018).
 
Previously, I addressed §864(c)(8), along with §1446(f)’s associated withholding rules, in several blogs (http://millentaxandlegal.ch/blogs.html) and at the Operational Taxes for Banks, Europe Conference in Zurich last November (http://millentaxandlegal.ch/speaking-engagements.html). In the latter case, however, I concentrated on the treatment of PTP interests, as the audience consisted primarily of bankers, rather than investors or fund managers.