[Federal Register Volume 85, Number 216 (Friday, November 6, 2020)]
[Rules and Regulations]
[Pages 70958-70972]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-21165]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9919]
RIN 1545-BO86


Gain or Loss of Foreign Persons From Sale or Exchange of Certain 
Partnership Interests

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and temporary regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains regulations that provide guidance for 
certain foreign persons that recognize gain or loss from the sale or 
exchange of an interest in a partnership that is engaged in a trade or 
business within the United States. The regulations also affect 
partnerships that, directly or indirectly, have foreign persons as 
partners.

DATES: Effective date: These regulations are effective on November 6, 
2020.
    Applicability dates: For dates of applicability, see Sec. Sec.  
1.864(c)(8)-1(j) and 1.897-7(c).

FOR FURTHER INFORMATION CONTACT: Chadwick Rowland or Ronald M. 
Gootzeit, (202) 317-6937 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Background

    On December 27, 2018, the Department of the Treasury (the 
``Treasury Department'') and the IRS published proposed regulations 
(REG-113604-18) under section 864(c)(8) in the Federal Register (83 FR 
66647) (the ``proposed regulations''). Section 864(c)(8) was added to 
the Internal Revenue Code (the ``Code'') by the Tax Cuts and Jobs Act, 
Public Law 115-97 (2017) (the ``Act''), which was enacted on December 
22, 2017. The proposed regulations provide rules for determining the 
amount of gain or loss treated as effectively connected with the 
conduct of a trade or business within the United States (``effectively 
connected gain'' or ``effectively connected loss'') under section 
864(c)(8), including certain rules that coordinate section 864(c)(8) 
with other relevant sections of the Code.
    The Treasury Department and the IRS received written comments with 
respect to the proposed regulations. All written comments received in 
response to the proposed regulations are available at 
www.regulations.gov or upon request.

[[Page 70959]]

No public hearing on the proposed regulations was requested or held.
    The Treasury Department and the IRS have also published proposed 
regulations (REG-105476-18) in the Federal Register relating to the 
withholding of tax and information reporting with respect to certain 
dispositions by a foreign person of an interest in a partnership that 
is engaged in the conduct of a trade or business within the United 
States (the ``proposed withholding regulations''). See 84 FR 21198 (May 
13, 2019). The Treasury Department and the IRS plan to publish final 
withholding and information reporting regulations in a later issue of 
the Federal Register.

Summary of Comments and Explanation of Revisions

I. Overview

    The final regulations retain the basic approach and structure of 
the proposed regulations with certain revisions. This Summary of 
Comments and Explanation of Revisions section discusses the comments 
received in response to the solicitation of comments in the proposed 
regulations and explains the revisions made in response to those 
comments.

II. Comments and Revisions to Proposed Sec.  1.864(c)(8)-1

A. Determining Deemed Sale EC Gain or Deemed Sale EC Loss

    Section 864(c)(8)(A) provides that gain or loss of a nonresident 
alien individual or foreign corporation (a ``foreign transferor'') from 
the sale, exchange, or other disposition (``transfer'') of an interest 
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 if the partnership had sold all of its 
assets at fair market value (the deemed sale limitation). The proposed 
regulations illustrate how to determine the deemed sale limitation 
described in section 864(c)(8)(B), which the proposed regulations refer 
to as the aggregate deemed sale EC (``ADSEC'') amount. Once the ADSEC 
amount has been determined for each applicable category of gain or 
loss, the foreign transferor's outside gain or loss in each category is 
compared to the relevant ADSEC gain or ADSEC loss amount for that 
category to determine the amount of effectively connected gain or 
effectively connected loss under section 864(c)(8). In general, this 
amount is determined through a three-step process. Step one determines 
the amount of gain or loss from each partnership asset as if the 
partnership conducted a deemed sale of all of its assets on the date of 
transfer (these amounts, deemed sale gain or deemed sale loss). Step 
two determines the amount of the deemed sale gain or loss that would be 
treated as effectively connected gain or loss with respect to each 
asset (these amounts are referred to as deemed sale EC gain or deemed 
sale EC loss). Finally, step three determines the foreign transferor's 
distributive share of the deemed sale EC gain or deemed sale EC loss 
amounts determined in step two.
    As noted in the preceding paragraph, step two requires the gain or 
loss from the deemed sale of each partnership asset to be analyzed to 
determine if the gain or loss is properly characterized as effectively 
connected gain or effectively connected loss. Sourcing determinations 
are often material in determining whether gain or loss is effectively 
connected with the conduct of a trade or business within the United 
States. See, for example, sections 864(c)(2) and (3). Because the 
sourcing rules in the Code and regulations are generally fact-specific, 
the application of these rules in the context of the deemed sale 
required by section 864(c)(8)(B) is unclear. For example, it is unclear 
how to apply the sourcing rules and principles contained in sections 
865(e)(2)(A) and (e)(3) (and the regulations implementing those 
sections) (the U.S. office rule) to the deemed sale of partnership 
property required by section 864(c)(8)(B). Specifically, the 
application of the U.S. office rule depends upon factual determinations 
made regarding the underlying sale; that is, whether it is attributable 
to an office or other fixed place of business in the United States, 
and, with respect to inventory property, whether it is sold for use, 
disposition, or consumption outside the United States and whether an 
office or other fixed place of business maintained by the taxpayer in 
the foreign country materially participated in the sale. In a deemed 
sale, however, the required facts are generally not determinable 
because a sale has not actually occurred. Therefore, to address this 
lack of required facts and provide guidance on how to apply the 
sourcing provisions to deemed sales, the proposed regulations provide 
rules that serve as a proxy for the factual determinations that apply 
for purposes of sourcing deemed sale gain and loss and, in turn, for 
determining deemed sale EC gain and loss.
    In general, proposed Sec.  1.864(c)(8)-1(c)(2)(i) treats all deemed 
sale gain and loss as attributable to an office or other fixed place of 
business maintained by the partnership in the United States, and does 
not treat inventory property as sold for use, disposition, or 
consumption outside the United States in a sale in which an office or 
other fixed place of business maintained by the partnership in a 
foreign country materially participates. Thus, the rule in proposed 
Sec.  1.864(c)(8)-1(c)(2)(i) provides simplifying factual assumptions 
that generally treat deemed sale gain and loss as U.S. source. An 
exception to this rule is provided in the proposed regulations if, 
during the ten-year period ending on the date of transfer, the asset in 
question produced no income or gain that was taxable as income that was 
effectively connected with the conduct of a trade or business within 
the United States by the partnership (or a predecessor), and the asset 
has not been used, or held for use, in the conduct of a trade or 
business within the United States by the partnership (or a predecessor) 
(the ``ten-year exception''). Proposed Sec.  1.864(c)(8)-1(c)(2)(ii).
    A comment on the interaction between section 864(c)(8) and the 
sourcing rules suggested that the simplifying factual assumptions 
supplied by the rule in proposed Sec.  1.864(c)(8)-1(c)(2)(i) may 
overstate the amount of effectively connected gain or loss on a deemed 
sale of the partnership's assets, as compared to an actual asset sale, 
by treating all gain or loss from the deemed sale as attributable to a 
U.S. office of the partnership, subject only to the ten-year exception. 
As a result, the proposed regulations would similarly overstate the 
amount of the deemed sale limitation. To address this concern, the 
comment suggested that in determining deemed sale EC gain and loss, the 
final regulations should aim to provide a result that is no better or 
worse than the result that would occur upon an actual asset sale by the 
partnership, but the comment acknowledged the difficulty in achieving 
this objective because the underlying source rules largely rely on 
fact-specific determinations.
    The Treasury Department and the IRS generally agree with the broad 
principles described in the comment regarding proposed Sec.  
1.864(c)(8)-1(c)(2). While these final regulations retain the basic 
framework of the proposed regulations, including the factual 
determinations regarding office attribution provided in proposed

[[Page 70960]]

Sec.  1.864(c)(8)-1(c)(2)(i), these final regulations adjust their 
effects by adding rules for sourcing gain or loss from specific assets 
that may be particularly difficult to source in a deemed sale. Sec.  
1.864(c)(8)-1(c)(2)(ii)(B) through (E).
1. Ten-Year Exception
    The final regulations provide that deemed sale EC gain and loss is 
determined by applying section 864 and the regulations thereunder. 
Sec.  1.864(c)(8)-1(c)(2)(i)(A). These final regulations retain the 
ten-year exception as an exception to the determination of deemed sale 
EC gain and loss under Sec.  1.864(c)(8)-1(c)(2)(i)(A). The ten-year 
exception is intended to remove assets that have no nexus to the United 
States from the deemed sale EC gain and loss determination; therefore, 
for these assets, a foreign transferor does not need to apply the rules 
described in Sec.  1.864(c)(8)-1(c)(2)(ii) to determine deemed sale EC 
gain and loss. One comment requested that the final regulations clarify 
that the ten-year exception applies to assets that were not held by the 
partnership for the full ten-year period. As requested by the comment, 
these final regulations modify the relevant testing period for the ten-
year exception to account for a partnership (including a predecessor of 
the partnership) that has not existed for at least ten years, or that 
has not held an asset for at least ten years, by shortening the 
relevant testing period to the lesser of the ten-year period ending on 
the date of the transfer or the period during which the partnership 
(and a predecessor of the partnership) held the asset. Sec.  
1.864(c)(8)-1(c)(2)(i)(B). In addition, to ensure that the ten-year 
exception is properly applied, these final regulations also modify the 
relevant testing period to include any period during which the foreign 
transferor (and a predecessor of the foreign transferor) held the 
asset. Id. Accordingly, an asset will not qualify for the ten-year 
exception if it generated effectively connected income or effectively 
connected gain for the foreign transferor (or a predecessor of the 
foreign transferor), or if the asset was used in the conduct of a trade 
or business within the United States by the foreign transferor (or a 
predecessor of the foreign transferor), within the relevant testing 
period. Id.
2. Rules for Sourcing Deemed Sale Gain and Loss for Purposes of 
Determining Deemed Sale EC Gain and Loss
    Proposed Sec.  1.864(c)(8)-1(c)(2)(i) treats all gain or loss from 
the deemed sale of an asset as attributable to an office or other fixed 
place of business maintained by the partnership in the United States, 
and does not treat inventory property as sold for use, disposition, or 
consumption outside the United States in a sale in which an office or 
other fixed place of business maintained by the partnership in a 
foreign country materially participated. These final regulations make 
several changes to the general rule provided in proposed Sec.  
1.864(c)(8)-1(c)(2)(i) in response to the comment described in section 
II.A of this Summary of Comments and Explanation of Revisions; these 
final regulations also clarify the scope of this rule. First, these 
final regulations clarify that the general rule applies only for 
purposes of applying section 865(e)(2)(A) to personal property held by 
the partnership on the date of the deemed sale. Sec.  1.864(c)(8)-
1(c)(2)(ii)(A). Second, these final regulations provide additional 
sourcing rules for determining the foreign source portion of deemed 
sale gain and loss attributable to specific assets included in the 
deemed sale. Sec.  1.864(c)(8)-1(c)(2)(ii)(B) through (E). The specific 
assets are inventory, intangibles, and depreciable personal property. 
Additional sourcing rules are needed because gain or loss from actual 
sales of each of these assets would be subject to specific sourcing 
rules under the Code, but sourcing deemed sale gain or loss under those 
rules would generally require facts that are not determinable in a 
deemed sale. These final regulations also clarify that if the 
partnership does not maintain an office or other fixed place of 
business in the United States (within the meaning of section 
864(c)(5)(A) and Sec.  1.864-7), neither the U.S. office attribution 
described in Sec.  1.864(c)(8)-1(c)(2)(ii)(A), nor the additional 
sourcing rules described in Sec.  1.864(c)(8)-1(c)(2)(ii)(B) through 
(E), will apply. Sec.  1.864(c)(8)-1(c)(2)(ii)(A). Finally, the final 
regulations reorganize the proposed regulations to account for the 
changes described in this section II.A.2 of this Summary of Comments 
and Explanation of Revisions, and the phrase in proposed Sec.  
1.864(c)(8)-1(c)(2)(i) regarding use, disposition, or consumption 
outside the United States is removed to conform with changes made to 
the general rule and the addition of a specific inventory sourcing 
rule.
    The asset-specific rules provided in Sec.  1.864(c)(8)-
1(c)(2)(ii)(B) through (E) utilize available facts as a proxy for the 
sourcing results, and the attendant effectively connected 
determinations, that would occur in an actual sale by the partnership 
of inventory, intangibles, or depreciable personal property. These 
asset-specific rules use existing sourcing rules and principles to 
provide fair, administrable rules that can be applied consistently. 
Specifically, the foreign source portion of deemed sale gain or loss 
attributable to inventory property (as defined in section 865(i)(1)) is 
determined using a proxy method that is based on historical data (as 
suggested by the comment); the foreign source portion of deemed sale 
gain and loss attributable to intangibles (as defined in section 
865(d)(2)) is determined using a proxy method that is based on the 
partnership's historic income; and the foreign source portion for 
certain deemed sale gain or loss attributable to depreciable personal 
property (as defined in section 865(c)(4)(A)) is determined under a 
recapture principle and, to the extent applicable, a proxy method that 
is also based on historical data. Additionally, these final regulations 
add a material change in circumstances rule in Sec.  1.864(c)(8)-
1(c)(2)(ii)(E) that applies if, based on a material change in 
circumstances, the asset-specific rules for inventory property or 
intangibles do not reach an appropriate sourcing result.
    Thus, to the extent that deemed sale gain or loss is attributable 
to inventory, intangibles, or depreciable personal property, the 
sourcing result for these assets is determined by first applying Sec.  
1.864(c)(8)-1(c)(2)(ii)(A) and then, to the extent applicable, the 
asset-specific rules provided in Sec.  1.864(c)(8)-1(c)(2)(ii)(B) 
through (D), or the material change in circumstances rule provided in 
Sec.  1.864(c)(8)-1(c)(2)(ii)(E). Accordingly, the U.S. office 
attribution rule described in Sec.  1.864(c)(8)-1(c)(2)(ii)(A) applies 
to these assets only to the extent that the deemed sale gain or loss 
exceeds the relevant foreign source portion determined under the 
relevant rule provided in Sec.  1.864(c)(8)-1(c)(2)(ii)(B) through (E).
i. Look-Back Rule for Inventory Property
    The comment on the interaction between section 864(c)(8) and the 
sourcing rules recommended that the Treasury Department and IRS 
consider a separate rule for sourcing deemed sales of inventory based 
on historical data showing how inventory sales were sourced by the 
partnership over a specified period. The Treasury Department and the 
IRS agree with the suggestion.
    Section 1.864(c)(8)-1(c)(2)(ii)(B) provides a look-back rule for 
determining the foreign source portion of deemed sale gain or loss 
attributable to inventory property (as defined in section 865(i)(1), 
but not including gain sourced by reference to section

[[Page 70961]]

865(c)(2)) that is held by the partnership on the date of the deemed 
sale. Specifically, the general rule provided in Sec.  1.864(c)(8)-
1(c)(2)(ii)(A) will not apply, and the deemed sale of inventory 
property will not be treated as attributable to an office or other 
fixed place of business maintained by the partnership in the United 
States, to the extent of foreign source inventory gain or loss. This 
amount is determined by multiplying deemed sale gain and loss 
attributable to inventory by a fraction that determines the foreign 
source inventory ratio. The numerator of the fraction includes the 
gross income of the partnership that is attributable to foreign source 
gain or loss from inventory property (as determined under the rules of 
sections 865(b) and 865(e)) sold within the shorter of the period 
comprised of the partnership's three taxable years immediately 
preceding the date of the deemed sale, or the existence of the 
partnership (measured by partnership taxable years); the denominator of 
the fraction is the total gross income of the partnership that is 
attributable to inventory over that period.
    This approach addresses the concerns raised in the comment by 
looking to the partnership's past operations to determine the relevant 
sourcing result for inventory property, instead of assuming that all of 
the gain or loss from the deemed sale of inventory property is 
attributable to a U.S. office (unless the ten-year exception is met). 
That is, because sourcing the deemed sale gain or loss attributable to 
inventory property will require facts that are not available in a 
deemed sale, this approach sources the deemed sale gain or loss by 
reference to the actual sourcing results from prior sales of inventory 
property during the look-back period, as evidenced by the foreign 
source inventory ratio. This rule can be applied by taxpayers and 
administered by the government with certainty.
ii. Look-Back Rule for Intangibles
    The comment on the interaction between section 864(c)(8) and the 
sourcing rules also discussed how the simplifying factual assumptions 
supplied by the rule in proposed Sec.  1.864(c)(8)-1(c)(2)(i) may 
overstate the amount of effectively connected gain or loss with respect 
to a deemed sale of intangibles held by the partnership. While 
acknowledging the difficulty of determining the source of deemed sale 
gain and loss attributable to intangibles, the comment described an 
approach that would apply a separate rule to determine the source of 
deemed sale gain and loss attributable to intangibles in lieu of the 
simplifying factual assumptions supplied by the rule in proposed Sec.  
1.864(c)(8)-1(c)(2)(i) as it applies to intangibles. The Treasury 
Department and the IRS agree that it is difficult to source deemed sale 
gain or loss attributable to intangibles and that a single, 
administrable rule to address this issue is preferable. To minimize the 
difficulty of applying the sourcing rules to intangible property and to 
provide more certainty, the final regulations provide a separate rule 
for intangibles (including going concern value) that determines the 
foreign source portion of deemed sale gain or loss attributable to 
intangibles by using a proxy method that is based on the source of the 
partnership's historic gross ordinary income.
    Section 1.864(c)(8)-1(c)(2)(ii)(C) provides a look-back rule for 
determining the foreign source portion of deemed sale gain or loss 
attributable to an intangible (as defined in section 865(d)(2)) held by 
the partnership on the date of the deemed sale. This rule is similar to 
the look-back rule for inventory property because it provides that the 
deemed sale of an intangible will not be treated as attributable to an 
office or other fixed place of business maintained by the partnership 
in the United States to the extent of a foreign source amount. This 
amount is determined by multiplying deemed sale gain or loss 
attributable to an intangible by the foreign source intangible ratio.
    Thus, the approach for determining the foreign source amount with 
respect to intangibles employs the same general approach provided for 
inventory property, with certain modifications. Deemed sale gain or 
loss attributable to intangibles, like that attributable to inventory 
property, cannot be reliably sourced in a deemed sale because an actual 
sale has not occurred. However, unlike inventory property, intangibles 
may not have relevant historical data indicating how deemed sale gain 
and loss would be sourced in an actual sale (for example, some 
intangibles do not generate an identifiable income stream on which a 
sourcing proxy could be based). To address this issue, the numerator of 
the foreign source intangible ratio includes the foreign source gross 
ordinary income of the partnership (other than from dispositions of 
depreciable or amortizable property) during the shorter of the period 
comprised of the partnership's three taxable years preceding the date 
of the deemed sale or the existence of the partnership (measured by 
partnership taxable years), to the extent that such income was not 
effectively connected with the conduct of a trade or business within 
the United States; the denominator includes the total gross ordinary 
income of the partnership (other than from dispositions of depreciable 
or amortizable property) during that period. Sec.  1.864(c)(8)-
1(c)(2)(ii)(C)(1) and (2). This foreign source intangible ratio looks 
specifically to the historic gross ordinary income of the partnership 
(as opposed to all the historic gross income of the partnership) in 
order to more accurately reflect the partnership's income derived from 
the use of the intangibles in the ordinary course of its trade or 
business. This rule does not apply to the extent of any depreciation 
adjustments (as defined in section 865(c)(4)(B)) with respect to an 
amortizable intangible; instead, the rules regarding depreciable 
personal property will apply to such adjustments.
iii. Special Rules for Foreign Source Inventory Ratio and Foreign 
Source Intangible Ratio
    The foreign source inventory ratio and foreign source intangible 
ratio may in certain circumstances cause mathematically impossible 
results or unclear application if cost of goods sold exceed gross 
receipts. Additional rules were added to address these concerns. First, 
the foreign source inventory ratio and the foreign source intangible 
ratio cannot exceed one. Sec.  1.864(c)(8)-1(c)(2)(ii)(B) and (C). 
Second, if the foreign source gross income attributable to inventory or 
the foreign gross ordinary income is not positive, then respectively 
the foreign source inventory ratio or the foreign source intangible 
ratio is zero. Id. Third, if the foreign source gross income 
attributable to inventory is positive, but the total gross income 
attributable to inventory is not positive, or if the foreign gross 
ordinary income is positive, but the total gross ordinary income is not 
positive, then respectively the foreign source inventory ratio or the 
foreign source intangible ratio is one. Id.
iv. Depreciable Personal Property
    Section 1.864(c)(8)-1(c)(2)(ii)(D) provides a two-part approach for 
determining the foreign source portion of deemed sale gain and loss 
attributable to depreciable personal property: The first part applies a 
recapture principle to the extent of depreciation adjustments taken 
with respect to the property, and the second part focuses on where the 
property is located to the extent the property has deemed sale gain in 
excess of its depreciation adjustments or if the property has deemed 
sale loss.
    Section 1.864(c)(8)-1(c)(2)(ii)(D)(1) applies a recapture principle 
by

[[Page 70962]]

providing that the deemed sale of depreciable personal property (as 
defined in section 865(c)(4)(A)), or the deemed sale of an amortizable 
intangible (as defined in section 865(d)(2)), will not be treated as 
attributable to an office or other fixed place of business maintained 
by the partnership in the United States to the extent the deemed sale 
gain is treated as sourced outside the United States after applying 
section 865(c)(1) at the time of the deemed sale. In contrast to the 
other sourcing rules that could apply to assets held by the partnership 
on the date of the deemed sale, the recapture rule provided in section 
865(c)(1) can be applied with certainty at the time of the deemed sale 
because it is based on data that is available at the time of the deemed 
sale.
    For deemed sale gain in excess of the depreciation adjustments with 
respect to depreciable personal property (other than an amortizable 
intangible), or for deemed sale loss from depreciable personal property 
(other than an amortizable intangible), Sec.  1.864(c)(8)-
1(c)(2)(ii)(D)(2) provides that the relevant sourcing determination is 
made based on where the property is located. See Sec.  1.864(c)(8)-
1(c)(2)(ii)(C) and section II.A.2.ii of this Summary of Comments and 
Explanation of Revisions for the rule that applies to gain in excess of 
depreciation adjustments with respect to an amortizable intangible. 
Although section 865(c)(2) sources the excess gain as if it were 
attributable to inventory property, such treatment would require 
further clarification for purposes of these final regulations. 
Specifically, in contrast to inventory property, depreciable personal 
property may not have historical data readily available that evidences 
the location of the economic activity associated with the property or 
that otherwise indicates how the excess gain or loss would be sourced 
in an actual sale. To address this issue, while also providing a clear 
and administrable rule, Sec.  1.864(c)(8)-1(c)(2)(ii)(D)(2) sources the 
excess gain or loss attributable to depreciable personal property based 
on the location of the property.
v. Material Change in Circumstances Rule
    Section 1.864(c)(8)-1(c)(2)(ii)(E) provides a material change in 
circumstances rule for inventory and intangibles. If this rule applies, 
the foreign source portion of deemed sale gain or loss attributable to 
inventory property or intangibles may be determined by applying the 
relevant rule of Sec.  1.864(c)(8)-1(c)(2)(ii)(B) or (C) by reference 
to a modified look-back period.
    The Treasury Department and the IRS have determined that the 
general rule provided in Sec.  1.864(c)(8)-1(c)(2)(ii)(A) and the 
asset-specific determinations provided in Sec.  1.864(c)(8)-
1(c)(2)(ii)(B) and (C) will reach an appropriate sourcing result in 
most cases; that is, an actual sale of the partnership's assets has not 
occurred, so relevant sourcing information with respect to an actual 
sale of the assets on the date of the deemed sale will not be readily 
determinable in most cases, and the look-back rules use the 
partnership's past operations as a proxy for reaching a sourcing 
determination with respect to certain assets included in the deemed 
sale. See sections II.A.2.i and II.A.2.ii of this Summary of Comments 
and Explanation of Revisions.
    The Treasury Department and the IRS realize, however, that the 
look-back rules provided in Sec.  1.864(c)(8)-1(c)(2)(ii)(B) and (C) 
for inventory property and intangibles could reach incorrect sourcing 
results in certain cases; specifically, if a material change in 
circumstances occurred during the relevant look-back period described 
in paragraph Sec.  1.864(c)(8)-1(c)(2)(ii)(B)(1) or Sec.  1.864(c)(8)-
1(c)(2)(ii)(C)(1), the partnership's historical data for the entire 
look-back period may not be an accurate proxy for reaching a sourcing 
determination with respect to deemed sale gain or loss attributable to 
such property. In these cases, the final regulations allow taxpayers to 
use this material change in circumstances rule to remedy an incorrect 
sourcing result with respect to inventory property and intangibles.
    The application of Sec.  1.864(c)(8)-1(c)(2)(ii)(E), therefore, is 
limited to situations in which a material change in circumstances 
causes the look-back rule provided in Sec.  1.864(c)(8)-1(c)(2)(ii)(B), 
or the look-back rule provided in Sec.  1.864(c)(8)-1(c)(2)(ii)(C), to 
reach an inappropriate sourcing result; that is, a sourcing result that 
is materially different from the sourcing result that would occur if 
the applicable look-back period began on the date on which the material 
change in circumstance occurred and ended on the last day of the 
partnership's taxable year immediately preceding the year in which the 
deemed sale occurs (the modified look-back period).\1\ If the material 
change in circumstances rule applies, the applicable sourcing rule for 
inventory or intangibles may be applied by reference to the modified 
look-back period. Sec.  1.864(c)(8)-1(c)(2)(ii)(E). The determination 
of whether a sourcing result is materially different is determined by 
comparing the foreign source inventory ratio or foreign source 
intangible ratio provided in Sec.  1.864(c)(8)-1(c)(2)(ii)(B) or (C) 
(as applicable) with the foreign source inventory ratio or foreign 
source intangible ratio if that ratio were determined by reference to 
the modified look-back period. The sourcing result is not materially 
different unless the percentage point difference between the two ratios 
described in the preceding sentence is at least 30 percentage points. 
Id. See Example 2 in Sec.  1.864(c)(8)-1(c)(2)(iii).
---------------------------------------------------------------------------

    \1\ The material change in circumstances rule cannot apply to a 
change in circumstances that occurs in the year of the deemed sale 
because such a change does not occur during the relevant look-back 
period and, in that case, there is no modified look-back period 
against which to measure the results that otherwise occur under 
Sec.  1.864(c)(8)-1(c)(2)(ii)(B) or (C).
---------------------------------------------------------------------------

B. Treaty Coordination

    A comment questioned whether the rules provided in proposed Sec.  
1.864(c)(8)-1(c) for determining a foreign transferor's deemed sale EC 
gain or deemed sale EC loss were intended to apply in the treaty 
context without regard to whether the partnership in fact had a 
permanent establishment in the United States under the terms of an 
income tax treaty at the time of the transfer.
    These final regulations clarify that the U.S. office attribution 
rule described in Sec.  1.864(c)(8)-1(c)(2)(ii)(A) does not apply 
unless the partnership maintains an office or other fixed place of 
business in the United States. A partnership without a U.S. office or 
other fixed place of business will also generally not have a permanent 
establishment in the United States. In addition, the treaty 
coordination rule in Sec.  1.864(c)(8)-1(f) takes into account an 
applicable treaty when computing the amount of a foreign transferor's 
distributive share of deemed sale EC gain and deemed sale EC loss. As a 
result, for purposes of Sec.  1.864(c)(8)-1(c)(3) (that is, the third 
step in the three-step process to determine the foreign transferor's 
aggregate deemed sale EC items), gain or loss derived by the foreign 
transferor attributable to assets deemed sold that would be exempt from 
tax under an applicable U.S. income tax treaty if disposed of by the 
partnership are not taken into account.
    The final regulations retain the general rule that prevents 
taxation of gain on assets that do not form part of a permanent 
establishment, but also address certain gains that may be taxed

[[Page 70963]]

without regard to whether there is a permanent establishment (for 
example, gains from the disposition of certain U.S. real property 
interests). The final regulations also modify the structure of proposed 
Sec.  1.864(c)(8)-1(f) by consolidating proposed Sec.  1.864(c)(8)-
1(f)(1) through (3) into a single paragraph and make three additional 
changes.
    First, Sec.  1.864(c)(8)-1(f) clarifies that a foreign transferor 
is eligible for benefits under an income tax treaty only if the 
transferor meets the requirements of a limitation on benefits article, 
if any, in the treaty between the jurisdiction in which the foreign 
transferor is resident and the United States.
    Second, Sec.  1.864(c)(8)-1(f) modifies proposed Sec.  1.864(c)(8)-
1(f)(2), which stated that ``[t]reaty provisions applicable to gains 
from the alienation of property forming part of a permanent 
establishment, including gains from the alienation of a permanent 
establishment in the United States, apply to the transfer by a foreign 
transferor of an interest in a partnership with a permanent 
establishment in the United States.'' The final regulations clarify 
that a gains article that permits the taxation of gain from the 
alienation of property forming part of a permanent establishment or 
fixed place of business in the United States also permits the taxation 
of gain from the alienation of a partnership interest, to the extent 
the partnership's assets deemed sold under section 864(c)(8) form a 
part of the U.S. permanent establishment or fixed place of business of 
the partnership. Thus, the final regulations remove from the 
description of an applicable gains provision the phrase ``including 
gains from the alienation of a permanent establishment,'' as that 
phrase, as used in certain treaties, merely illustrates one application 
of the underlying words and is not a separate rule. This approach also 
is consistent with the statutory framework under section 864(c)(8), 
which determines the amount of effectively connected gain or loss of a 
foreign transferor based on the amount of the transferor's distributive 
share of gain or loss that would have been effectively connected if the 
partnership had sold all of its assets at fair market value.
    Finally, Sec.  1.864(c)(8)-1(f) adds a rule coordinating these 
regulations with treaty provisions governing the disposition of United 
States real property interests, which allow the United States to tax 
gain derived from the disposition of the United States real property 
interest without regard to whether the U.S. real property interest 
forms a part of a partnership's permanent establishment or fixed place 
of business in the United States. Under this coordination rule, if, 
after applying treaty benefits in paragraph (c)(3) of this section, the 
only gains or losses that would be taken into account are gains or 
losses attributable to United States real property interests, the 
foreign transferor determines its effectively connected gain and 
effectively connected loss pursuant to section 897 and not under 
section 864(c)(8). This addition is consistent with the approach taken 
in the proposed regulations that the gain would be computed under 
section 897 rather than section 864(c)(8). See section IV of the 
Explanation of Provisions section of the preamble to the proposed 
regulations.

C. Partner-Specific Exclusions and Exceptions

    A comment requested that the final regulations more clearly address 
the interaction of section 864(c)(8) and Sec.  1.864(c)(8)-1 with 
provisions of the Code providing for an exemption from U.S. federal 
income tax. The Treasury Department and the IRS agree with this 
suggestion; accordingly, the final regulations provide that a foreign 
transferor's distributive share of deemed sale EC gain or loss does not 
include any amount that is excluded from the foreign transferor's gross 
income or otherwise exempt from U.S. Federal income tax by reason of an 
applicable provision of the Code. Section 1.864(c)(8)-1(c)(3)(i). For 
this purpose, the final regulations refer to sections 864(b)(2), 
872(b), and 883 as examples. Id.
    Similarly, Sec.  1.864(c)(8)-1(c)(3) is modified to provide that a 
foreign transferor's distributive share of deemed sale EC gain or 
deemed sale EC loss does not include any amount to which an exception 
under section 897 applies, such as section 897(k) or section 897(l), 
provided that amount is not otherwise treated as effectively connected 
income under a provision of the Code. This rule, which was provided in 
proposed Sec.  1.864(c)(8)-1(c)(2) as part of the determination of a 
foreign transferor's deemed sale EC gain and deemed sale EC loss, is 
moved to Sec.  1.864(c)(8)-1(c)(3) in these final regulations because 
the exceptions under section 897(k) and section 897(l) are specific to 
the foreign transferor. This modification is intended to make the three 
step-process for determining the foreign transferor's aggregate deemed 
sale EC amounts more cohesive by placing all partner-specific 
adjustments in step 3.

D. Section 731 Distributions

    Under the proposed regulations, a foreign transferor determines the 
amount of outside gain and loss recognized on the transfer of a 
partnership interest under all relevant provisions of the Code and 
regulations, including any applicable nonrecognition provision. 
Proposed Sec.  1.864(c)(8)-1(b)(2). Although section 864(c)(8)(E) 
authorizes regulations or other guidance with respect to the 
application of section 864(c)(8) to nonrecognition transactions, the 
proposed regulations generally do not provide special rules that apply 
to nonrecognition transactions. But see proposed Sec.  1.864(c)(8)-1(h) 
(the anti-stuffing rule). However, the Treasury Department and the IRS 
recognized that certain nonrecognition transactions, for example 
certain section 731 distributions, may have the effect of reducing gain 
or loss that would be taken into account under the rules provided in 
the proposed regulations. The preamble to the proposed regulations, 
therefore, requested comments regarding whether sections of the Code 
other than section 864(c)(8) adequately address transactions that rely 
on section 731 distributions to reduce the scope of assets subject to 
U.S. federal income taxation as a result of section 864(c)(8) and 
proposed Sec.  1.864(c)(8)-1. A comment identified several relevant 
Code sections and analyzed the application of these sections to 
transactions involving section 731 distributions. The Treasury 
Department and the IRS continue to study this issue and will, if 
necessary, address it through future rulemaking.

E. Information Exchange Between a Partnership and Non-Controlling 
Partners

    A comment requested that foreign partners that do not own a 
controlling interest in a partnership be permitted to estimate their 
effectively connected gain or loss for purposes of section 864(c)(8) 
because non-controlling partners may not be able to obtain from the 
partnership the information required to perform the computations under 
these rules. The Treasury Department and the IRS have determined that 
such a rule is not needed under section 864(c)(8) because the proposed 
withholding regulations address this issue. Specifically, the proposed 
withholding regulations provide rules in proposed Sec.  1.864(c)(8)-2 
that facilitate and encourage the transfer of information between a 
foreign partner and a partnership for purposes of section 864(c)(8). 
The information reporting

[[Page 70964]]

requirements of the proposed withholding regulations require the 
partnership to provide the foreign partner with the information 
necessary to perform the computations under these rules, even if the 
foreign partner does not hold a controlling interest in the 
partnership. However, this comment will be considered as part of the 
proposed withholding regulations, which will be finalized separately in 
a later issue of the Federal Register.

F. Section 754 Elections

    A comment requested a special rule for any foreign transferor that 
has a difference between its basis in the partnership interest and its 
share of the partnership's inside basis that occurs because no section 
754 election is in effect at the time of transfer; this special rule 
would, in effect, deem a section 754 election. Specifically, the 
comment indicated that a foreign transferor may not have negotiated for 
the partnership to make a section 754 election upon acquisition of an 
interest in a partnership engaged in a trade or business within the 
United States because the transferor considered Rev. Rul. 91-32, 1991-1 
C.B. 107, to be incorrect. As a result, upon a later transfer of the 
acquired partnership interest, the foreign transferor would have 
received a different result under the rules in the section 864(c)(8) 
proposed regulations than if the partnership had instead sold all of 
its assets and then liquidated. Because this result occurs due to the 
failure to make a section 754 election and the mismatches that follow 
from that failure, the Treasury Department and the IRS have determined 
that it would be inappropriate to adopt a special rule in these 
circumstances.

G. Clarification of Section 897 Coordination Rule With Respect to 
Nonrecognition Provisions

    Proposed Sec.  1.864(c)(8)-1(d) coordinates the taxation of United 
States real property interests under section 897(g) with section 
864(c)(8) by providing that when a partnership holds United States real 
property interests and a transfer of an interest in that partnership is 
subject to section 864(c)(8) because the partnership 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). However, the proposed regulations did not 
provide explicit guidance on the application of the section 897 
coordination rule when a foreign transferor transfers its partnership 
interest in a nonrecognition transaction. The final regulations clarify 
the interaction between the section 897 coordination rule and the 
nonrecognition provision described in Sec.  1.864(c)(8)-1(b)(2)(ii). 
Specifically, Sec.  1.864(c)(8)-1(d) provides that any transfer of an 
interest in a partnership as part of a nonrecognition transaction will 
not be subject to section 864(c)(8) to the extent that the gain or loss 
on the transfer is not recognized; instead, if the partnership owns one 
or more United States real property interests, section 897(g) and the 
regulations thereunder will apply with respect to the unrecognized gain 
or loss.

III. Applicability Dates

    The proposed regulations were proposed to apply to transfers 
occurring on or after November 27, 2017. Because the provisions 
contained in this rulemaking are finalized after June 22, 2019, these 
regulations generally apply to transfers occurring on or after December 
26, 2018 (that is, the date on which the proposed regulations were 
filed with the Federal Register). See sections 7805(b)(1)(B) and (b)(2) 
and Sec. Sec.  1.864(c)(8)-1(j) and 1.897-7(c); see also the 
Applicability Dates section of the Preamble to the proposed 
regulations. While not subject to these final regulations, transfers 
occurring on or after November 27, 2017, but before December 26, 2018, 
are subject to section 864(c)(8). In addition, these final regulations 
apply to amounts taken into account on or after December 26, 2018, 
pursuant to an installment sale (as defined in section 453(b)) 
occurring on or after November 27, 2017, and before December 26, 2018. 
Sec. Sec.  1.864(c)(8)-1(j) and 1.897-7(c). This rule is consistent 
with the manner in which installment sales are treated under existing 
law. See, e.g., Snell v. Commissioner, 97 F.2d 891 (5th Cir. 1938) (the 
tax laws in effect for the year the installment gain is recognized 
apply to the gain); see also Estate of Kearns v. Commissioner, 73 T.C. 
1223 (1980); Klein v. Commissioner, 42 T.C. 1000 (1964); Rev. Rul. 79-
22, 1979-1 C.B. 275.

Special Analyses

    These final regulations are not subject to review under section 
6(b) of Executive Order 12866 pursuant to the Memorandum of Agreement 
(April 11, 2018) between the Treasury Department and the Office of 
Management and Budget regarding review of tax regulations.
    The Treasury Department and the IRS have assessed that the final 
regulations do not establish a new collection of information nor modify 
an existing collection that requires the approval of the Office of 
Management and Budget under the Paperwork Reduction Act (44 U.S.C. 
chapter 35).
    Section 864(c)(8) and the final regulations generally apply to 
nonresident alien individuals and foreign corporations on the transfer 
of an interest in a partnership that is engaged in a trade or business 
within the United States, and not directly to the trade or business the 
partnership conducts in the United States. Under section 605 of the 
Regulatory Flexibility Act (5 U.S.C. chapter 6), the Treasury 
Department and the IRS certify that the final regulations will not have 
a significant economic impact on a substantial number of small business 
entities. The reason is that the final regulations generally apply to 
nonresident alien individuals and foreign corporations on the transfer 
of an interest in a partnership and not directly to domestic small 
business entities. Pursuant to section 7805(f), the notice of proposed 
rulemaking preceding these final regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business. No comments were received.

Drafting Information

    The principal authors of these regulations are Chadwick Rowland and 
Ronald M. Gootzeit, Office of the Associate Chief Counsel 
(International). However, other personnel from the Treasury Department 
and the IRS participated in their development.

Statement of Availability

    Revenue rulings and other guidance cited in this document are 
published in the Internal Revenue Bulletin (or Cumulative Bulletin) and 
are available from the Superintendent of Documents, U.S. Government 
Publishing Office, Washington, DC 20402, or by visiting the IRS website 
at https://www.irs.gov.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read in part as follows:


[[Page 70965]]


    Authority:  26 U.S.C. 7805 * * *
    Section 1.864(c)(8)-1 also issued under 26 U.S.C. 864(c)(8) and 
897(g).
* * * * *
    Section 1.897-7 also issued under 26 U.S.C. 897(g).
* * * * *


0
Par. 2. Section 1.864(c)(8)-1 is added to read as follows:


Sec.  1.864(c)(8)-1  Gain or loss by foreign persons on the disposition 
of certain partnership interests.

    (a) Overview. This section provides rules and definitions under 
section 864(c)(8). Paragraph (b) of this section provides the general 
rule treating gain or loss recognized by a nonresident alien individual 
or foreign corporation from the sale or exchange of a partnership 
interest as effectively connected gain or effectively connected loss. 
Paragraph (c) of this section provides rules for determining the 
limitations on the amount of effectively connected gain or effectively 
connected loss under section 864(c)(8) and paragraph (b) of this 
section. Paragraph (d) of this section provides rules regarding 
coordination with section 897. Paragraph (e) of this section provides 
rules regarding certain tiered partnerships. Paragraph (f) of this 
section provides rules regarding U.S. income tax treaties. Paragraph 
(g) of this section provides definitions. Paragraph (h) of this section 
provides a rule regarding certain contributions of property to a 
partnership. Paragraph (i) of this section contains examples 
illustrating the rules set forth in this section. Paragraph (j) of this 
section provides the applicability date.
    (b) Gain or loss treated as effectively connected gain or loss--(1) 
In general. Notwithstanding any other provision of subtitle A of the 
Internal Revenue Code, if a foreign transferor owns, directly or 
indirectly, an interest in a partnership that is engaged in the conduct 
of a trade or business within the United States, outside capital gain, 
outside capital loss, outside ordinary gain, or outside ordinary loss 
(each as defined in paragraph (b)(2) of this section) recognized by the 
foreign transferor on the transfer of all (or any portion) of the 
interest is treated as effectively connected gain or effectively 
connected loss, subject to the limitations described in paragraph 
(b)(3) of this section. Except as provided in paragraph (d) of this 
section, this section does not apply to prevent any portion of the gain 
or loss that is otherwise treated as effectively connected gain or 
effectively connected loss under provisions of the Internal Revenue 
Code other than section 864(c)(8) from being so treated.
    (2) Determination of outside gain and loss--(i) In general. The 
amount of gain or loss recognized by the foreign transferor in 
connection with the transfer of its partnership interest is determined 
under all relevant provisions of the Internal Revenue Code and the 
regulations thereunder. See, e.g., Sec. Sec.  1.741-1(a) and 1.751-
1(a)(2). For purposes of this section, the amount of gain or loss that 
is treated as capital gain or capital loss under sections 741 and 751 
is referred to as outside capital gain or outside capital loss, 
respectively. The amount of gain or loss that is treated as ordinary 
gain or ordinary loss under sections 741 and 751 is referred to as 
outside ordinary gain or outside ordinary loss, respectively.
    (ii) Nonrecognition provisions. A foreign transferor's gain or loss 
recognized in connection with the transfer of its partnership interest 
does not include gain or loss to the extent that the gain or loss is 
not recognized by reason of one or more nonrecognition provisions of 
the Internal Revenue Code.
    (3) Limitations. For purposes of applying this section, this 
paragraph (b)(3) limits the amount of gain or loss recognized by a 
foreign transferor that may be treated as effectively connected gain or 
effectively connected loss.
    (i) Capital gain limitation. Outside capital gain recognized by a 
foreign transferor is treated as effectively connected gain to the 
extent it does not exceed aggregate deemed sale EC capital gain 
determined under paragraph (c)(3)(ii)(B) of this section.
    (ii) Capital loss limitation. Outside capital loss recognized by a 
foreign transferor is treated as effectively connected loss to the 
extent it does not exceed aggregate deemed sale EC capital loss 
determined under paragraph (c)(3)(ii)(B) of this section.
    (iii) Ordinary gain limitation. Outside ordinary gain recognized by 
a foreign transferor is treated as effectively connected gain to the 
extent it does not exceed aggregate deemed sale EC ordinary gain 
determined under paragraph (c)(3)(ii)(A) of this section.
    (iv) Ordinary loss limitation. Outside ordinary loss recognized by 
a foreign transferor is treated as effectively connected loss to the 
extent it does not exceed aggregate deemed sale EC ordinary loss 
determined under paragraph (c)(3)(ii)(A) of this section.
    (c) Amount treated as effectively connected with the conduct of a 
trade or business within the United States. This paragraph (c) 
describes the steps to be followed in computing the limitations 
described in paragraph (b)(3) of this section.
    (1) Step 1: Determine deemed sale gain and loss. Determine the 
amount of gain or loss that the partnership would recognize with 
respect to each of its assets (other than interests in partnerships 
described in paragraph (e) of this section) upon a deemed sale of all 
of the partnership's assets on the date of the transfer of the 
partnership interest described in paragraph (b)(1) of this section 
(deemed sale). For this purpose, a deemed sale is treated as a sale by 
the partnership to an unrelated person of each of its assets (tangible 
and intangible) in a fully taxable transaction for cash in an amount 
equal to the fair market value of each asset (taking into account 
section 7701(g)) immediately before the partner's transfer of the 
interest in the partnership. For rules concerning the deemed sale of 
certain partnership interests, see paragraph (e) of this section.
    (2) Step 2: Determine deemed sale EC gain and loss--(i) In 
general--(A) Effectively connected determination. With respect to each 
asset deemed sold in paragraph (c)(1) of this section, determine the 
amount of gain or loss from the deemed sale that would be treated as 
effectively connected gain or effectively connected loss (including by 
reason of section 897). Gain described in this paragraph (c)(2) is 
referred to as deemed sale EC gain, and loss described in this 
paragraph (c)(2) is referred to as deemed sale EC loss. Section 864 and 
the regulations thereunder apply for purposes of determining whether 
deemed sale gain or loss would be treated as effectively connected gain 
or loss. See paragraph (c)(2)(ii) of this section for sourcing rules 
that apply for purposes of determining deemed sale EC gain and deemed 
sale EC loss.
    (B) 10-year exception. For purposes of applying paragraph 
(c)(2)(i)(A) of this section, gain or loss from the deemed sale of an 
asset (other than a United States real property interest within the 
meaning of section 897(c)) will not be treated as deemed sale EC gain 
or deemed sale EC loss if--
    (1) No income or gain produced by the asset was taxable as income 
that was effectively connected with the conduct of a trade or business 
within the United States by the partnership (or the foreign transferor, 
a predecessor of the foreign transferor, or a predecessor of the 
partnership) during the lesser of the ten-year period ending on the 
date of the transfer or the period for which the partnership (and, if 
applicable, the foreign transferor, a predecessor of the foreign 
transferor, and a predecessor of the partnership) held the asset; and
    (2) The asset has not been used, or held for use, in the conduct of 
a trade

[[Page 70966]]

or business within the United States by the partnership (or the foreign 
transferor, a predecessor of the foreign transferor, or a predecessor 
of the partnership) during that same period.
    (ii) Sourcing rules for determining deemed sale EC gain and deemed 
sale EC loss--(A) In general. For purposes of applying section 
865(e)(2)(A) in connection with the determination of deemed sale EC 
gain and deemed sale EC loss under this paragraph (c)(2)(ii)(A), except 
to the extent provided in paragraphs (c)(2)(ii)(B) through (E) of this 
section, the deemed sale of an asset will be treated as attributable to 
an office or other fixed place of business maintained by the 
partnership in the United States. However, if the partnership does not 
maintain an office or other fixed place of business in the United 
States (within the meaning of section 864(c)(5)(A) and Sec.  1.864-7), 
neither the office attribution described in this paragraph 
(c)(2)(ii)(A), nor the rules of paragraphs (c)(2)(ii)(B) through (E) of 
this section, will apply.
    (B) Look-back rule for sale of inventory property. The deemed sale 
of inventory property (as defined in section 865(i)(1)) will not be 
treated as attributable to an office or other fixed place of business 
maintained by the partnership in the United States to the extent of 
foreign source inventory gain or loss. Foreign source inventory gain or 
loss is determined by multiplying the deemed sale gain or deemed sale 
loss attributable to inventory property by the foreign source inventory 
ratio. The foreign source inventory ratio cannot exceed one. If the 
amount in paragraph (c)(2)(ii)(B)(1) of this section is not positive, 
the foreign source inventory ratio is zero. If the amount in paragraph 
(c)(2)(ii)(B)(1) of this section is positive, but the amount in 
paragraph (c)(2)(ii)(B)(2) of this section is not positive, the foreign 
source inventory ratio is one. The foreign source inventory ratio is--
    (1) The gross income of the partnership from sources without the 
United States (as determined under sections 865(b) and 865(e)(2)) that 
was attributable to inventory property sold during the lesser of--
    (i) The period comprised of the partnership's three taxable years 
immediately preceding the date of the deemed sale, or
    (ii) The period beginning on the date the partnership (or any of 
its predecessors) was formed and ending on the last day of the 
partnership's taxable year immediately preceding the date of the deemed 
sale; over
    (2) The total gross income of the partnership that was attributable 
to inventory property sold during that same period.
    (C) Look-back rule for intangibles. The deemed sale of an 
intangible (as defined in section 865(d)(2), including going concern 
value) will not be treated as attributable to an office or other fixed 
place of business maintained by the partnership in the United States to 
the extent of foreign source intangible gain or loss. Foreign source 
intangible gain or loss is determined by multiplying the deemed sale 
gain or deemed sale loss from an intangible, without regard to any gain 
described in section 865(d)(4)(A), by the foreign source intangible 
ratio. The foreign source intangible ratio cannot exceed one. If the 
amount in paragraph (c)(2)(ii)(C)(1) of this section is not positive, 
the foreign source intangible ratio is zero. If the amount in paragraph 
(c)(2)(ii)(C)(1) of this section is positive, but the amount in 
paragraph (c)(2)(ii)(C)(2) of this section is not positive, the foreign 
source inventory ratio is one. The foreign source intangible ratio is--
    (1) The gross ordinary income (other than from dispositions of 
depreciable or amortizable property) of the partnership from sources 
without the United States that was not effectively connected with the 
conduct of a trade or business within the United States, during the 
lesser of--
    (i) The period comprised of the partnership's three taxable years 
immediately preceding the date of the deemed sale, or
    (ii) The period beginning on the date the partnership (or any of 
its predecessors) is formed and ending on the last day of the 
partnership's taxable year immediately preceding the year in which the 
deemed sale occurs; over
    (2) The total gross ordinary income (other than from dispositions 
of depreciable or amortizable property) of the partnership during that 
period.
    (D) Depreciable personal property--(1) Depreciation recapture. The 
deemed sale of depreciable personal property (as defined in section 
865(c)(4)(A)), including from the sale of an amortizable intangible (as 
defined in section 865(d)(2)), will not be treated as attributable to 
an office or other fixed place of business maintained by the 
partnership in the United States to the extent the deemed sale gain 
would be treated as from sources outside the United States after 
applying section 865(c)(1) at the time of the deemed sale.
    (2) Gain in excess of depreciation or loss with respect to 
depreciable personal property. For purposes of this section, if the 
deemed sale of depreciable personal property (other than an amortizable 
intangible) results in deemed sale gain in excess of the property's 
depreciation adjustments (as defined in section 865(c)(4)(B)), or 
results in deemed sale loss, attribution to an office or other fixed 
place of business maintained by the partnership in the United States 
with respect to the excess deemed sale gain, or deemed sale loss, will 
be determined based on where the property is located: If the property 
is located outside the United States, the excess deemed sale gain, or 
the deemed sale loss, will not be treated as attributable to an office 
or other fixed place of business maintained by the partnership in the 
United States; if the property is located within the United States, the 
excess deemed sale gain, or the deemed sale loss, will be treated as 
attributable to an office or other fixed place of business maintained 
by the partnership in the United States.
    (E) Material change in circumstances rule. If a material change in 
circumstances occurred that causes the applicable rule provided in 
paragraph (c)(2)(ii)(B) or (C) of this section to provide a sourcing 
result that is materially different from the sourcing result that would 
occur if the applicable period described in paragraph (c)(2)(ii)(B)(1) 
or (c)(2)(ii)(C)(1) of this section began on the date on which the 
material change in circumstance occurred and ended on the last day of 
the partnership's taxable year immediately preceding the year in which 
the deemed sale occurs (the modified look-back period), the applicable 
rule provided in paragraph (c)(2)(ii)(B) or (C) of this section may be 
applied by reference to the modified look-back period. The difference 
between the sourcing results is determined by comparing the foreign 
source inventory ratio (as described in paragraph (c)(2)(ii)(B) of this 
section) or the foreign source intangible ratio (as described in 
paragraph (c)(2)(ii)(C) of this section), as applicable, with the 
foreign source inventory ratio or foreign source intangible ratio, as 
applicable, if that ratio were determined by reference to the modified 
look-back period. For purposes of this paragraph (c)(2)(ii)(E), the 
sourcing results will not be materially different unless the percentage 
point difference between the ratios described in the preceding sentence 
is at least 30 percentage points.
    (iii) Examples. This paragraph (c)(2)(iii) provides examples that 
illustrate the rules of paragraph (c)(2)(ii) of this section. Except as 
otherwise provided, the following facts apply for purposes of this 
paragraph (c)(2)(iii). FP is a foreign corporation and a partner in 
PRS, a partnership that is engaged in the conduct of a trade or 
business within

[[Page 70967]]

the United States (the U.S. Business) and a business in Country A (the 
Country A Business). Both businesses purchase inventory property and 
sell the purchased inventory property to unrelated customers; this is 
the only income-generating activity carried on by the businesses. PRS 
maintains an office or fixed place of business within the U.S. (within 
the meaning of section 864(c)(5)(A) and Sec.  1.864-7) and, for its 
U.S. business, PRS sells its inventory property through its U.S. 
office. For the Country A business, PRS sells its inventory property 
through its Country A office for consumption in Country A; PRS's 
Country A office materially participates in each sale. The gain or loss 
from the inventory sold through PRS's Country A office is treated as 
from sources without the United States and is not effectively connected 
with PRS's U.S. Business. In year 4, FP sells its entire interest in 
PRS, thereby triggering the deemed sale described in paragraph (c)(1) 
of this section. In the deemed sale, PRS recognizes $10x of gain on the 
sale of its inventory property (the only asset PRS holds other than 
goodwill and going concern value). The 10-year exception provided in 
paragraph (c)(2)(i)(B) of this section does not apply.
    (A) Example 1: Determining foreign source inventory gain--(1) 
Facts. Based on PRS's sales records for the three taxable years 
immediately preceding the date of the deemed sale, PRS's gross income 
from sources without the United States that is attributable to sales of 
inventory property is $12x and PRS's total gross income attributable to 
sales of inventory property during that period is $30x.
    (2) Analysis. To determine foreign source inventory gain or loss 
described in paragraph (c)(2)(ii)(B) of this section, the $10x deemed 
sale gain attributable to inventory property is multiplied by PRS's 
foreign source inventory ratio. PRS's foreign source inventory ratio is 
PRS's gross income from sources without the United States that are 
attributable to sales of inventory property within PRS's three taxable 
years preceding the date of the deemed sale, over PRS's total gross 
income attributable to sales of inventory property during the same 
period. Thus, based on PRS's sales records from the three taxable years 
preceding the date of the deemed sale, the foreign source inventory 
gain for PRS's inventory is $4x (the $10x deemed sale gain attributable 
to inventory multiplied by the foreign source inventory ratio of $12x 
over $30x).
    (B) Example 2: Determining deemed sale EC gain attributable to 
inventory property under the material change in circumstances rule--(1) 
Facts. The facts are the same as in paragraph (c)(2)(iii)(A)(1) of this 
section (the facts of Example 1 in this paragraph (c)(2)(iii)), except 
that at the beginning of year 3 (PRS's taxable year immediately 
preceding the date of the deemed sale), PRS started a new business in 
Country B (the Country B Business) to take advantage of favorable 
market prospects for its products in Country B. For the Country B 
Business, PRS sells its inventory property through its Country B office 
for consumption in Country B; PRS's Country B office materially 
participates in each such sale. The gain or loss from the inventory 
sold through PRS's Country B office is foreign source gain or loss. 
Also, at the beginning of year 3, PRS substantially reduced its U.S. 
Business as a result of market factors. As a result of these changes in 
year 3, 95% of PRS's inventory property is sold in its Country A 
Business and Country B Business (collectively, the Foreign Businesses) 
beginning on the date in which these changes occurred; accordingly, 5% 
of PRS' inventory property is sold in its U.S. Business after these 
changes. Based on PRS's sales records for the three taxable years 
preceding the date of the deemed sale, PRS's gross income from sources 
without the United States that are attributable to sales of inventory 
property is $15x and PRS's total gross income attributable to sales of 
inventory property during that period is $30x; for year 3, PRS's gross 
income from sources without the United States that are attributable to 
sales of inventory property is $9.5x, and PRS's total gross income 
attributable to sales of inventory property in Year 3 is $10x.
    (2) Analysis. The material change in circumstances rule described 
in paragraph (c)(2)(ii)(E) of this section applies if due to a material 
change in circumstances, the sourcing rule provided in paragraph 
(c)(2)(ii)(B) of this section provides a sourcing result that is 
materially different from the sourcing result that would occur if that 
sourcing rule was applied by reference to the modified look-back 
period; that is, the period beginning on the date in which a material 
chance in circumstances occurred and ending on the last day of the 
PRS's taxable year immediately preceding the date of the deemed sale. 
For this purpose, the reduction in PRS's U.S. business in year 3, 
coupled with the creation of the Country B Business in the same year, 
qualifies as a material change in circumstances. Thus, the modified 
look-back period consists of year 3; that is, the period starting at 
the beginning of year 3, the date in which the material change in 
circumstances occurred, and ending of the last day of year 3, the last 
day of PRS's taxable year immediately preceding the date of the deemed 
sale. Based on PRS's sales records for the three taxable years 
preceding the deemed sale, the foreign source inventory ratio, 
expressed as a percentage, is 50% ($15x attributable to PRS's gross 
income from sources without the United States with respect to sales of 
its inventory property, over $30x attributable to PRS's total gross 
income with respect to sales of its inventory property). Due to the 
material change in circumstances, however, 95% of PRS's inventory 
property is sold in its Foreign Businesses. ($9.5x attributable to 
PRS's gross income from sources without the United States with respect 
to sales of its inventory property, over $10x attributable to PRS's 
total gross income with respect to sales of its inventory property.) 
Accordingly, if PRS applied the sourcing rule provided in paragraph 
(c)(2)(ii)(B) of this section by reference to the modified look-back 
period, 95% ($9.5x/$10x), or $9.5x, of the gain would be attributable 
to sales for PRS's Foreign Businesses (gain from sources without the 
United States), and only 5% ($.5x/$10x), or $0.5x, of the gain would be 
attributable to sales for PRS's U.S. Business (gain from United States 
sources). The excess of the foreign source inventory ratio determined 
by reference to the modified look-back period (expressed as a 
percentage), over the foreign source inventory ratio (also expressed as 
a percentage) is 45%; that is 95% (as determined under the modified 
look-back period) minus 50% (as determined under the foreign source 
inventory ratio). Accordingly, the sourcing results are materially 
different because the 45 percentage point difference is greater than 
the 30 percentage point threshold provided in paragraph (c)(2)(ii)(E) 
of this section. Thus, the material change in circumstances rule of 
paragraph (c)(2)(ii)(E) of this section applies and the foreign source 
inventory gain determined under paragraph (c)(2)(ii)(B) of this 
section, determined by reference to the modified look-back period, is 
$9.5x; that is, the deemed sale gain attributable to inventory property 
($10x), multiplied by the foreign source inventory ratio determined by 
reference to the modified look-back period ($9.5x/$10x).
    (3) Step 3: Determine the foreign transferor's distributive share 
of deemed sale EC gain or deemed sale EC loss--(i) In general. A 
foreign transferor's

[[Page 70968]]

distributive share of deemed sale EC gain or deemed sale EC loss with 
respect to each asset is the amount of the deemed sale EC gain and 
deemed sale EC loss determined under paragraph (c)(2) of this section 
that would have been allocated to the foreign transferor by the 
partnership under all applicable Internal Revenue Code sections 
(including section 704) upon the deemed sale described in paragraph 
(c)(1) of this section, taking into account allocations of tax items 
applying the principles of section 704(c), including any remedial 
allocations (see Sec.  1.704-3(d)), and any section 743(b) basis 
adjustments (see Sec.  1.743-1(j)(3)). For this purpose, a foreign 
transferor's distributive share of deemed sale EC gain or deemed sale 
EC loss does not include any amount that is excluded from the foreign 
transferor's gross income or otherwise exempt from U.S. Federal income 
tax by reason of an applicable provision of the Internal Revenue Code 
(including, for example, by reason of section 864(b)(2), 872(b), or 
883). Similarly, a foreign transferor's distributive share of deemed 
sale EC gain or deemed sale EC loss does not include any amount to 
which an exception under section 897 applies, such as section 897(k) or 
section 897(l), if that amount is not otherwise treated as effectively 
connected under a provision of the Code. For rules regarding the 
determination of a foreign transferor's distributive share of deemed 
sale EC gain and deemed sale EC loss under an applicable U.S. income 
tax treaty, see paragraph (f) of this section.
    (ii) Aggregate deemed sale EC items--(A) Ordinary gain or loss. A 
foreign transferor's aggregate deemed sale EC ordinary gain (if the net 
aggregate of the foreign transferor's distributive share of the deemed 
sale EC ordinary gain and loss is a gain) or aggregate deemed sale EC 
ordinary loss (if the net aggregate of the foreign transferor's 
distributive share of the deemed sale EC ordinary gain and loss is a 
loss) is determined by taking into account--
    (1) The portion of the foreign transferor's distributive share of 
deemed sale EC gain and deemed sale EC loss that is attributable to the 
deemed sale of the partnership's assets that are section 751(a) 
property; and
    (2) Deemed sale EC gain and deemed sale EC loss from the deemed 
sale of assets that are section 751(a) property that would be allocated 
to the foreign transferor with respect to interests in partnerships 
that are engaged in the conduct of a trade or business within the 
United States under paragraph (e)(1)(ii) of this section upon the 
deemed asset sales described in paragraph (e)(1)(i) of this section.
    (B) Capital gain or loss. A foreign transferor's aggregate deemed 
sale EC capital gain (if the net aggregate of the foreign transferor's 
distributive share of the deemed sale EC capital gain and loss is a 
gain) or aggregate deemed sale EC capital loss (if the net aggregate of 
the foreign transferor's distributive share of the deemed sale EC 
capital gain and loss is a loss) is determined by taking into account--
    (1) The portion of the foreign transferor's distributive share of 
deemed sale EC gain and deemed sale EC loss that is attributable to the 
deemed sale of assets that are not section 751(a) property; and
    (2) Deemed sale EC gain and deemed sale EC loss from the sale of 
assets that are not section 751(a) property and that would be allocated 
to the foreign transferor with respect to all interests in partnerships 
that are engaged in the conduct of a trade or business within the 
United States under paragraph (e)(1)(ii) of this section upon the 
deemed asset sales described in paragraph (e)(1)(i) of this section.
    (iii) Partial transfers. If a foreign transferor transfers less 
than all of its interest in a partnership, then for purposes of 
paragraph (c)(3)(i) of this section, the foreign transferor's 
distributive share of deemed sale EC gain and deemed sale EC loss is 
determined by reference to the amount of deemed sale EC gain or deemed 
sale EC loss determined under paragraph (c)(3)(i) of this section that 
is attributable to the portion of the foreign transferor's partnership 
interest that was transferred.
    (d) Coordination with section 897. If a foreign transferor 
transfers an interest in a partnership in a transfer that is subject to 
section 864(c)(8) and the partnership owns one or more United States 
real property interests (as defined in section 897(c)), then the 
foreign transferor determines its effectively connected gain and 
effectively connected loss under this section, and not pursuant to 
section 897(g). Accordingly, with respect to a transfer that is subject 
to section 864(c)(8), section 864(c)(8)(C) does not reduce the amount 
of gain or loss treated as effectively connected gain or loss under 
this section. For rules regarding a transfer not subject to section 
864(c)(8) of an interest in a partnership that owns one or more United 
States real property interests, see section 897(g) and the regulations 
thereunder. If a foreign transferor transfers an interest in a 
partnership in the manner described in paragraph (b)(2)(ii) of this 
section, the transfer is treated as not subject to section 864(c)(8) to 
the extent of the gain or loss that is not recognized; instead, if the 
partnership owns one or more United States real property interests at 
the time of transfer, the rules of section 897(g) and the regulations 
thereunder apply to the unrecognized gain or loss.
    (e) Tiered partnerships--(1) Transfers of upper-tier partnerships. 
Assets sold in a deemed sale described in paragraph (c)(1) of this 
section do not include interests in partnerships that are engaged in 
the conduct of a trade or business within the United States or 
interests in partnerships that hold, directly or indirectly, 
partnerships that are engaged in the conduct of a trade or business 
within the United States. Rather, if a foreign transferor transfers an 
interest in a partnership (upper-tier partnership) that owns, directly 
or indirectly, an interest in one or more partnerships that are engaged 
in the conduct of a trade or business within the United States, then--
    (i) Beginning with the lowest-tier partnership that is engaged in 
the conduct of a trade or business within the United States in a chain 
of partnerships and going up the chain, each partnership that is 
engaged in the conduct of a trade or business within the United States 
is treated as selling its assets in a deemed sale in accordance with 
the principles of paragraph (c)(1) of this section; and
    (ii) Each partnership must determine its deemed sale EC gain and 
deemed sale EC loss in accordance with the principles of paragraph 
(c)(2) of this section, and determine the distributive share of deemed 
sale EC gain and deemed sale EC loss for each partner that is either a 
partnership (in which the foreign transferor is a direct or indirect 
partner) or a foreign transferor, in accordance with the principles of 
paragraph (c)(3)(i) of this section.
    (2) Transfers by upper-tier partnerships. If a foreign transferor 
is a direct or indirect partner in an upper-tier partnership and the 
upper-tier partnership transfers an interest in a partnership that is 
engaged in the conduct of a trade or business within the United States 
(including a partnership held indirectly through one or more 
partnerships), then the principles of this section (including paragraph 
(e)(1) of this section) apply with respect to the gain or loss on the 
transfer that is allocated to the foreign transferor by the upper-tier 
partnership.
    (3) Coordination with section 897. For purposes of this paragraph 
(e), a lower-tier partnership that holds one or more United States real 
property interests is

[[Page 70969]]

treated as engaged in the conduct of a trade or business within the 
United States.
    (f) Treaty coordination. This paragraph (f) describes how paragraph 
(c)(3) of this section applies in the case of a transfer of an interest 
in a partnership by a foreign transferor that is eligible for benefits 
under an applicable U.S. income tax treaty. As a general matter, a 
foreign transferor must satisfy the requirements of the limitation on 
benefits article, if any, in the treaty between the jurisdiction in 
which the transferor is resident and the United States to be eligible 
for treaty benefits. In the case of a foreign transferor that is 
entitled to treaty benefits, in determining the foreign transferor's 
distributive share of deemed sale EC gain and deemed sale EC loss, gain 
or loss derived by the foreign transferor attributable to assets deemed 
sold that would be exempt from tax under an applicable U.S. income tax 
treaty if disposed of by the partnership are not taken into account 
under paragraph (c)(3) of this section. In general, gain or loss on the 
alienation of a partnership interest will be treated as effectively 
connected gain or loss under section 864(c)(8) to the extent that the 
gain or loss is either attributable to assets forming part of a U.S. 
permanent establishment or fixed place of business, or taxable under a 
provision governing the disposition of United States real property 
interests. Gain or loss from the alienation of a partnership interest 
will be considered gain or loss attributable to the alienation of 
assets forming part of a permanent establishment or fixed place of 
business in the United States to the extent the assets deemed sold 
under section 864(c)(8) form a part of the U.S. permanent establishment 
or fixed place of business of the partnership. If, however, after 
applying treaty benefits in paragraph (c)(3) of this section, the only 
gains or losses that would be taken into account are gains or losses 
attributable to United States real property interests, the foreign 
transferor determines its effectively connected gain and effectively 
connected loss pursuant to section 897 and not under this section.
    (g) Definitions. The following definitions apply for purposes of 
this section.
    (1) Effectively connected gain. The term effectively connected gain 
means gain that is treated as effectively connected with the conduct of 
a trade or business within the United States.
    (2) Effectively connected loss. The term effectively connected loss 
means loss treated as effectively connected with the conduct of a trade 
or business within the United States.
    (3) Foreign transferor. The term foreign transferor means a 
nonresident alien individual or foreign corporation.
    (4) Section 751(a) property. The term section 751(a) property means 
unrealized receivables described in section 751(c) and inventory items 
described in section 751(d).
    (5) Transfer. The term transfer means a sale, exchange, or other 
disposition, and includes a distribution from a partnership to a 
partner to the extent that gain or loss is recognized on the 
distribution, as well as a transfer treated as a sale or exchange under 
section 707(a)(2)(B).
    (h) Anti-stuffing rule. If a foreign transferor (or a person that 
is related to a foreign transferor within the meaning of section 267(b) 
or 707(b)) transfers property (including another partnership interest) 
to a partnership in a transaction with a principal purpose of reducing 
the amount of gain treated as effectively connected gain, or increasing 
the amount of loss treated as effectively connected loss, under section 
864(c)(8) or section 897, the transfer is disregarded for purposes of 
section 864(c)(8) or section 897, as appropriate.
    (i) Examples. This paragraph (i) provides examples that illustrate 
the rules of this section. Except as otherwise provided, the following 
facts are presumed for purposes of this paragraph (i). FP is a foreign 
corporation. USP is a domestic corporation. PRS is a partnership that 
was formed on January 1, 2018, when FP and USP each contributed $100x 
in cash. PRS has made no distributions and received no contributions 
other than those described in the preceding sentence. FP's adjusted 
basis in its interest in PRS is $100x. X is a foreign corporation that 
is unrelated to FP, USP, or PRS. Upon the formation of PRS, FP and USP 
entered into an agreement providing that all income, gain, loss, and 
deduction of PRS will be allocated equally between FP and USP. PRS is 
engaged in the conduct of a trade or business within the United States 
(the U.S. Business) and an unrelated business in Country A (the Country 
A Business). In a deemed sale described in paragraph (c)(1) of this 
section, gain or loss on assets of the U.S. Business would be treated 
as effectively connected gain or effectively connected loss, and gain 
or loss on assets of the Country A Business would not be so treated 
(including by reason of paragraph (c)(2)(i)(B) of this section). PRS 
has no liabilities.
    (1) Example 1. Deemed sale limitation--(i) Facts. On January 1, 
2019, FP sells its entire interest in PRS to X for $105x. FP does not 
qualify for the benefits of an income tax treaty between the United 
States and another country. Immediately before the sale, PRS's balance 
sheet appears as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   Fair market
                                                                               Adjusted basis         value
----------------------------------------------------------------------------------------------------------------
U.S. Business section 1231 asset............................................             $100x             $104x
Country A Business capital asset............................................              100x              106x
                                                                             -----------------------------------
    Total...................................................................              200x              210x
----------------------------------------------------------------------------------------------------------------

    (ii) Analysis--(A) Outside gain or loss. FP is a foreign transferor 
(within the meaning of paragraph (g)(3) of this section) and transfers 
(within the meaning of paragraph (g)(5) of this section) its interest 
in PRS to X. For purposes of this example, for simplicity, PRS is 
assumed to hold no section 751(a) property and depreciation recapture 
is assumed to be zero. FP recognizes a $5x capital gain under section 
741, which is an outside capital gain within the meaning of paragraph 
(b)(2)(i) of this section. Under paragraph (b)(1) of this section, FP's 
$5x capital gain is treated as effectively connected gain to the extent 
that it does not exceed the limitation described in paragraph (b)(3)(i) 
of this section, which is FP's aggregate deemed sale EC capital gain.
    (B) Deemed sale. FP's aggregate deemed sale EC capital gain is 
determined according to the three-step process set forth in paragraph 
(c) of this section. First, the amount of gain or loss that PRS would 
recognize with respect to each of its assets upon a deemed sale 
described in paragraph (c)(1) of this section is a $4x gain with 
respect to the U.S. Business section 1231 asset and a $6x gain with 
respect to the Country A Business capital asset. Second, under 
paragraph (c)(2) of this section, PRS's

[[Page 70970]]

deemed sale EC gain is $4x. Third, under paragraph (c)(3)(ii)(B) of 
this section, FP's aggregate deemed sale EC capital gain is $2x (that 
is, the aggregate of its distributive share of deemed sale EC gain 
attributable to the deemed sale of assets that are not section 751(a) 
property, which is 50% of $4x).
    (C) Limitation. Under paragraph (b)(3)(i) of this section, the $5x 
outside capital gain recognized by FP is treated as effectively 
connected gain to the extent that it does not exceed FP's $2x aggregate 
deemed sale EC capital gain. Accordingly, FP recognizes $2x of capital 
gain that is treated as effectively connected gain.
    (2) Example 2. Outside gain limitation--(i) Facts. On January 1, 
2019, FP sells its entire interest in PRS to X for $110x. FP does not 
qualify for the benefits of an income tax treaty between the United 
States and another country. Immediately before the sale, PRS's balance 
sheet appears as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   Fair market
                                                                               Adjusted basis         value
----------------------------------------------------------------------------------------------------------------
U.S. Business section 1231 asset............................................             $100x             $150x
Country A Business capital asset............................................              100x               70x
                                                                             -----------------------------------
    Total...................................................................              200x              220x
----------------------------------------------------------------------------------------------------------------

    (ii) Analysis--(A) Outside gain or loss. FP is a foreign transferor 
(within the meaning of paragraph (g)(3) of this section) and transfers 
(within the meaning of paragraph (g)(5) of this section) its interest 
in PRS to X. For purposes of this example, for simplicity, PRS is 
assumed to hold no section 751(a) property and depreciation recapture 
is assumed to be zero. FP recognizes a $10x capital gain under section 
741, which is an outside capital gain within the meaning of paragraph 
(b)(2)(i) of this section. Under paragraph (b)(1) of this section, FP's 
$10x capital gain is treated as effectively connected gain to the 
extent that it does not exceed the limitation described in paragraph 
(b)(3)(i) of this section, which is FP's aggregate deemed sale EC 
capital gain.
    (B) Deemed sale. FP's aggregate deemed sale EC capital gain is 
determined according to the three-step process set forth in paragraph 
(c) of this section. First, the amount of gain or loss that PRS would 
recognize with respect to each of its assets upon a deemed sale 
described in paragraph (c)(1) of this section is a $50x gain with 
respect to the U.S. Business section 1231 asset and a $30x loss with 
respect to the Country A Business capital asset. Second, under 
paragraph (c)(2) of this section, PRS's deemed sale EC gain is $50x. 
Third, under paragraph (c)(3)(ii)(B) of this section, FP's aggregate 
deemed sale EC capital gain is $25x (that is, the aggregate of its 
distributive share of deemed sale EC gain attributable to the deemed 
sale of assets that are not section 751(a) property, which is 50% of 
$50x).
    (C) Limitation. Under paragraph (b)(3)(i) of this section, the $10x 
outside capital gain recognized by FP is treated as effectively 
connected gain to the extent that it does not exceed FP's $25x 
aggregate deemed sale EC capital gain. Accordingly, FP recognizes $10x 
of capital gain that is treated as effectively connected gain.
    (3) Example 3. Interaction with section 751(a)--(i) Facts. On 
January 1, 2019, FP sells its entire interest in PRS to X for $95x. FP 
does not qualify for the benefits of an income tax treaty between the 
United States and another country. Through both its U.S. Business and 
its Country A Business, PRS holds inventory items and receivables that 
are section 751 property (as defined in Sec.  1.751-1(a)). Immediately 
before the sale, PRS's balance sheet appears as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   Fair market
                                                                               Adjusted basis         value
----------------------------------------------------------------------------------------------------------------
U.S. Business section 1231 asset............................................              $20x              $50x
U.S. Business inventory and receivables.....................................               30x               50x
Country A Business capital asset............................................              100x               80x
Country A Business inventory................................................               50x               10x
                                                                             -----------------------------------
    Total...................................................................              200x              190x
----------------------------------------------------------------------------------------------------------------

    (ii) Analysis--(A) Outside gain or loss. FP is a foreign transferor 
(within the meaning of paragraph (g)(3) of this section) and transfers 
(within the meaning of paragraph (g)(5) of this section) its interest 
in PRS to X. Under sections 741 and 751, FP recognizes a $10x ordinary 
loss and a $5x capital gain. See Sec.  1.751-1(a). Under paragraph 
(b)(2)(i) of this section, FP has outside ordinary loss equal to $10x 
and outside capital gain equal to $5x. Under paragraph (b)(1) of this 
section, FP's outside ordinary loss and outside capital gain are 
treated as effectively connected loss and effectively connected gain to 
the extent that each does not exceed the applicable limitation 
described in paragraph (b)(3) of this section. In the case of FP's 
outside ordinary loss, the applicable limitation is FP's aggregate 
deemed sale EC ordinary loss. In the case of FP's outside capital gain, 
the applicable limitation is FP's aggregate deemed sale EC capital 
gain.
    (B) Deemed sale. FP's aggregate deemed sale EC ordinary loss and 
aggregate deemed sale EC capital gain are determined according to the 
three-step process set forth in paragraph (c) of this section.
    (1) Step 1. The amount of gain or loss that PRS would recognize 
with respect to each of its assets upon a deemed sale described in 
paragraph (c)(1) of this section is as follows:

------------------------------------------------------------------------
                          Asset                             Gain/(loss)
------------------------------------------------------------------------
U.S. Business section 1231 asset........................            $30x
U.S. Business inventory and receivables.................             20x
Country A Business capital asset........................           (20x)
Country A Business inventory............................           (40x)
------------------------------------------------------------------------

    (2) Step 2. Under paragraph (c)(2) of this section, PRS's deemed 
sale EC gain and deemed sale EC loss must be

[[Page 70971]]

determined with respect to each asset. The amounts determined under 
paragraph (c)(2) of this section are as follows:

------------------------------------------------------------------------
                                                          Deemed sale EC
                          Asset                             gain/(loss)
------------------------------------------------------------------------
U.S. Business section 1231 asset........................            $30x
U.S. Business inventory and receivables.................             20x
Country A Business capital asset........................               0
Country A Business inventory............................               0
------------------------------------------------------------------------

    (3) Step 3. Under paragraph (c)(3)(ii)(B) of this section, FP's 
aggregate deemed sale EC capital gain is $15x (that is, the aggregate 
of its distributive share of deemed sale EC gain that is attributable 
to the deemed sale of assets that are not section 751(a) property, 
which is 50% of $30x) and FP's aggregate deemed sale EC ordinary loss 
is $0 (that is, the aggregate of its distributive share of deemed sale 
EC loss that is attributable to the deemed sale of assets that are 
section 751(a) property).
    (C) Limitation--(i) Capital gain. Under paragraph (b)(3)(i) of this 
section, the $5x outside capital gain recognized by FP is treated as 
effectively connected gain to the extent that it does not exceed FP's 
$15x aggregate deemed sale EC capital gain. Accordingly, the amount of 
FP's capital gain that is treated as effectively connected gain is $5x.
    (ii) Ordinary loss. Under paragraph (b)(3)(iv) of this section, the 
$10x outside ordinary loss recognized by FP is treated as effectively 
connected loss to the extent that it does not exceed FP's $0 aggregate 
deemed sale EC ordinary loss. Accordingly, the amount of FP's ordinary 
loss that is treated as effectively connected loss is $0.
    (4) Example 4. Coordination with income tax treaties--(i) Facts--
(A) Sale of interest. On January 1, 2019, FP sells its entire interest 
in PRS to X for $105x. Immediately before the sale, PRS's balance sheet 
appears as follows:

------------------------------------------------------------------------
                                                           Fair market
                                       Adjusted basis         value
------------------------------------------------------------------------
U.S. Business section 1231 asset....             $100x             $104x
Country A Business capital asset....              100x              106x
                                     -----------------------------------
    Total...........................              200x              210x
------------------------------------------------------------------------

    (B) Treaty benefits. FP is a qualified resident of Country A under 
a U.S. income tax treaty between the United States and Country A that 
is similar or identical in all material respects to the 2006 U.S. Model 
Income Tax Convention (the Treaty). PRS is treated as fiscally 
transparent for purposes of Country A tax law. PRS does not carry on 
its U.S. Business through a U.S. permanent establishment (PE).
    (ii) Analysis--(A) Outside gain or loss. FP is a foreign transferor 
(within the meaning of paragraph (g)(3) of this section) and transfers 
(within the meaning of paragraph (g)(5) of this section) its interest 
in PRS to X. For purposes of this example, for simplicity, PRS is 
assumed to hold no section 751(a) property and depreciation recapture 
is assumed to be zero. FP recognizes a $5x capital gain under section 
741, which is an outside capital gain within the meaning of paragraph 
(b)(2)(i) of this section. Under paragraph (b)(1) of this section, FP's 
$5x capital gain is treated as effectively connected gain to the extent 
that it does not exceed the limitation described in paragraph (b)(3)(i) 
of this section, which is FP's aggregate deemed sale EC capital gain.
    (B) Deemed sale. FP's aggregate deemed sale EC capital gain is 
determined according to the three-step process set forth in paragraph 
(c) of this section by taking into account the treaty coordination rule 
under paragraph (f) of this section.
    (1) Step 1. The amount of gain or loss that PRS would recognize 
with respect to each of its assets upon a deemed sale described in 
paragraph (c)(1) of this section is as follows:

------------------------------------------------------------------------
                          Asset                             Gain/(loss)
------------------------------------------------------------------------
U.S. Business section 1231 asset........................             $4x
Country A Business capital asset........................              6x
------------------------------------------------------------------------

    (2) Step 2. Under paragraph (c)(2) of this section, PRS's deemed 
sale EC gain is as follows:

------------------------------------------------------------------------
                          Asset                             Gain/(loss)
------------------------------------------------------------------------
U.S. Business section 1231 asset........................             $4x
Country A Business capital asset........................              0x
------------------------------------------------------------------------

    (3) Step 3. FP is eligible for benefits under the Treaty and 
derives the gain on the deemed sale of U.S. Business section 1231 
asset. Under paragraph (c)(3)(i) and paragraph (f) of this section, 
because gain from the disposition of the U.S. Business section 1231 
asset does not form part of a U.S. PE, the gain is exempt from U.S. tax 
under the Treaty, and is not taken into account in determining FP's 
distributive share of deemed sale EC gain under paragraphs (c)(3)(i) 
and paragraph (f) of this section. Therefore, FP's aggregate deemed 
sale EC capital gain is $0x under paragraph (c)(3)(ii)(B) of this 
section.
    (C) Limitation. Under paragraph (b)(3)(i) of this section, the $5x 
outside capital gain recognized by FP is not treated as effectively 
connected gain since all of it would exceed FP's $0x aggregate deemed 
sale EC capital gain.
    (j) Applicability date. This section applies to transfers occurring 
on or after December 26, 2018, and to amounts received on or after 
December 26, 2018, pursuant to an installment sale (as defined in 
section 453(b)) occurring on or after November 27, 2017.

0
Par. 3. Section 1.897-7 is added to read as follows:


Sec.  1.897-7  Treatment of certain partnership interests, trusts and 
estates under section 897(g).

    (a) through (b) [Reserved]. For further guidance, see Sec.  1.897-
7T(a) through (b).
    (c) Coordination with section 864(c)(8). Except as provided in 
Sec.  1.864(c)(8)-1, the amount of any money, and the fair market value 
of any property, received by a nonresident alien individual or foreign 
corporation in exchange for all or part of its interest in a 
partnership, trust, or estate will, to the extent attributable to 
United States real property interests, be considered as an amount 
received from the sale or exchange in the United States of such 
property. See also Sec.  1.864(c)(8)-1(h) for an anti-stuffing rule 
that may apply to transactions subject to section 897. This paragraph 
applies to transfers occurring on or after December 26, 2018, and to 
amounts received on or after December 26, 2018, pursuant to an 
installment sale (as defined in section 453(b)) occurring on or after 
November 27, 2017.

0
Par. 4. Section 1.897-7T is amended by adding paragraph (c) to read as 
follows:

[[Page 70972]]

Sec.  1.897-7T  Treatment of certain partnership interests as entirely 
U.S. real property interests under sections 897(g) and 1445(e) 
(temporary).

* * * * *
    (c) Coordination with section 864(c)(8). [Reserved]. For further 
guidance, see Sec.  1.897-7(c).

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
    Approved: September 10, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-21165 Filed 11-5-20; 8:45 am]
BILLING CODE 4830-01-P