The Tax Cuts and Jobs Act (“TCJA”) imposed tax on gains derived from the disposition of interests in partnerships carrying on a US trade or business.
To enforce this new regime against foreign partners, the TCJA also introduced a new withholding tax regime, Section 1446(f). Under this withholding regime, the purchaser of an interest in a partnership is required to withhold 10% of the sale proceeds and remit the withholding to the IRS. On May 7, 2019, Treasury promulgated proposed regulations setting out the operational rules of Section 1446(f).
While these new withholding tax rules apply to a limited number of transactions, the regime has a broader effect and will create an additional administrative burden for many partners and partnerships, some of whom have no foreign partners.
The following Q & A highlights some of the complexities of this withholding regime:
- Q: How is the withholding tax calculated?
A: 10% of the amount realized – if any portion of the foreign person’s gain would be treated as income effectively connected with a US trade or business (ECTI). Determining whether there is gain and the amount that is ECTI, if any, requires complex calculations and is based on a deemed sale of the partnership assets at fair market value, measured against the partnership’s adjusted basis in its assets.
How this rule will work in practice is to be seen. The transferee (who is the withholding agent) will often not have the information required to make this determination. The determination will be dependent on knowledge of the partnership’s assets and their respective fair market values.
- Q: Are there exceptions to withholding?
A: Yes. There are six exceptions to withholding for non-publicly traded partnerships, of which any one may be claimed, as applicable. These exceptions are:
- certification of non-foreign status, by obtaining a valid Form W-9 from the transferor,
- transferor certification of no realized gain on the transfer, taking into account the “hot assets” rules of Section 751,
- partnership certification that if all of its assets were sold at FMV, the net effectively connected gain resulting from the deemed sale would be less than 10 percent of the total gain,
- transferor certification that it was a partner in the partnership for all times during the immediately preceding three tax years and that the transferor’s allocable share of ECTI for each of those tax years was less than 10% of the transferor’s total distributive share of the partnership’s net income and that such distributive share was less than $1 million for each such tax year,
- notice by the transferor that a non-recognition provision of the IRC applies and provides a description of the application of such non-recognition provision, and
- transferor certification that it is not subject to tax on any gain from the transfer in accordance with an income tax treaty in effect between the US and a foreign country and that it qualifies for such treaty benefit.
- Q: How is the tax collected and remitted?
A: The transferee must withhold from the purchase price and remit to the IRS within 20 days of the transaction. Reporting is required on Forms 8288/8288-A (the same Forms used to report FIRPTA withholding). Remittance of the tax is also due within 20 days of the transaction.
- Q: Is the tax limited to sales of partnership interests?
A: No. The tax applies to any sale, exchange, or other disposition and includes certain distributions from a partnership to a partner. A distribution to a partner in excess of the partner’s adjusted basis in its partnership interest triggers gain recognition to the extent of the excess over the adjusted basis. Accordingly, these withholding rules will apply to such distributions. A distribution includes cash, property and reduction of liabilities. However, a partnership is permitted to rely on its books and records or on a certification provided by the partner to determine if there is realized gain by the partner.
- Q: Is the partnership affected by the sale of a partnership interest?
A: Yes. A partnership is affected in several ways. A partnership is required to: (i) determine gain, if any, on a deemed sale of its assets at FMV, (ii) withhold tax on a distribution to a partner in excess of such partner’s adjusted basis in its partnership interest, (iii) withhold tax for distributions to a transferee partner where such transferee fails to properly withhold, thereby requiring the partnership to determine whether the transferee withheld the proper amount, and (iv) determine whether certification for claims of exemption from withholding is correct and reliable (transferee must provide the partnership with transferor’s certification within 10 days of the transfer), among others.
- Q: Will a US person selling their interest in the partnership be affected by this?
A: Yes, unless such US person certifies US status by submitting a properly completed Form W-9. A transferor means any person, foreign or domestic, that transfers a partnership interest, and therefore refers to the person that directly owns the partnership interest. As such, a US person that holds an interest indirectly through a foreign partnership will be subject to these rules, unless a properly completed Form W-9 is provided.
- Q: Will the withholding tax be limited to the amount of tax on the US gain?
A: No. The withholding tax is based on the amount realized. However, the withholding tax may be limited or waived if a withholding certificate is requested by filing Form 8288-B, or if one of the exceptions to withholding applies. The preparation of a Form 8288-B will be challenging and time-consuming and will require information from the partnership with respect to the adjusted basis of assets and their fair market values.
- Q: If the sale relates to US real property interests, does the FIRPTA withholding regime nullify this regime?
A: Yes, but only if a withholding certificate is not requested (by filing Form 8288-B). Where a withholding certificate is requested, the withholding tax will be the higher amount of these two withholding regimes.
- Q: Does the withholding obligation apply to an upper-tier partnership formed in a foreign jurisdiction?
A: Yes. However, an upper-tier partnership is permitted to claim a credit on its Section 1446(a) withholding on effectively connected income for tax paid on withholding under Section 1446(f). This is because gain that an upper-tier partnership recognizes on the transfer of an interest in a lower-tier partnership engaged in the conduct of a US trade or business is included when calculating the upper-tier partnership’s effectively connected taxable income.
- Q: Does this withholding tax apply to Publicly Traded Partnerships (PTP)?
A: Yes. Withholding and reporting is required for the transfer of an interest in a PTP. The current suspension of the withholding on the disposition of a PTP interest will end when these proposed regulations become final. However, if the transfer of the PTP interest is effected through one or more brokers, the transferee is not required to withhold, and the withholding obligation is instead imposed on certain brokers involved with the transaction. There are five exceptions to withholding for PTPs. These are (i) certification of non-foreign status, (ii) the 10 percent exception, (iii) qualified current income distributions, (iv) withholding imposed under Section 3406 back-up withholding rules, and (v) claim of treaty benefits.
- Q: Is there a de minimis exception for these rules?
A: No. Except for the enumerated exceptions to withholding, there is no general de minimis exception to withholding.
The rules relating to the computation of the taxable gain and the related withholding tax on the sale of partnership interests are very complex and burdensome. Many partnerships will become responsible for obtaining documentation and reporting partnership transfers – a new obligation they may not be equipped to manage.
With so many open issues and the potential for errors or omissions, we encourage you to contact one of Friedman’s international tax specialists for assistance with any proposed transfer of a partnership interest or to gain a better understanding of these proposed regulations and the potential impact on future transactions, including distributions to partners in excess of their respective basis in their partnership interest.