Recent tax reform legislation, commonly known as the Tax Cuts and Jobs Act, imposed new withholding obligations under Section 1446(f) on the transfer by a non-U.S. owner of an interest in a partnership engaged in a U.S. trade or business. These withholding rules are intended to serve as a back-stop to newly enacted Section 864(c)(8), which generally provides that gain on the sale of a partnership interest by a non-U.S. partner can be subject to U.S. federal income tax to the extent that a sale of the underlying assets of the partnership would give rise to income that is considered to be "effectively connected" with the conduct of a U.S. trade or business ("effectively connected income" or "ECI"). On May 13, 2019, the Treasury Department and the IRS published proposed regulations regarding this new withholding requirement.
The IRS previously released two significant notices regarding this requirement. On December 29, 2017, the IRS released Notice 2018-08, which suspended the application of Section 1446(f) to dispositions of publicly traded interests ("PTIs") in publicly traded partnerships ("PTPs"). On April 2, 2018, the IRS released Notice 2018-29, in which the IRS announced its intention to issue regulations under Section 1446(f) regarding dispositions of non-PTP interests, provided interim guidance on which taxpayers may rely pending the issuance of such regulations and suspended the obligation of the partnership itself to withhold under Section 1446(f) upon a failure of the transferee to do so. Baker Botts previously discussed these notices here. The proposed regulations incorporate many of the rules described in Notice 2018-29 (with modifications) and also propose rules relating to dispositions of PTIs in PTPs.
The proposed regulations are generally proposed to be effective for transfers occurring on or after the date that is 60 days after the proposed regulations are finalized. Taxpayers may continue to rely on the rules in Notice 2018-08 and Notice 2018-29 for transfers that occur before such date. Certain key aspects of the proposed regulations are summarized below.
General Rules for Withholding on Transfers of Partnership Interests
Unless an exception applies, transferees are generally required to withhold 10% of the transferor's amount realized on the disposition of an interest in a partnership (other than a PTI in a PTP) where any portion of the gain would be treated under Section 864(c)(8) as ECI. The rules in the proposed regulations, discussed below, apply solely for purposes of the Section 1446(f) withholding requirement and do not affect a foreign person's tax liability resulting from the application of Section 864(c)(8).
In the case of transfers of partnership interests that are not PTIs in PTPs transferred through a broker, the proposed regulations provide that a transferee generally is not obligated to withhold, or has a reduced withholding obligation, under any of the following circumstances:
- The transferor provides the transferee with a certificate of non-foreign status. A valid Form W-9 may be used for this purpose. In cases where the transferor is a foreign partnership, the partners of the transferor may certify their non-foreign status, and the withholding amount may be reduced, based on the percentage of gain allocable to the non-foreign partners.
- The transferor certifies that the transferor did not realize any gain on the transfer. This certification may not be provided if the transferor has ordinary gain under Section 751(a) (sometimes referred to as "hot asset" gain) from the transfer, even if the transferor realizes an overall loss.
- The transferee receives notice from the partnership that, if the partnership sold all of its assets at fair market value, the amount of gain constituting ECI would be less than 10% of the total net gain.
- The transferor certifies that, for each of the three taxable years immediately prior to the year in which the transfer took place, (i) the transferor was at all times a partner in the partnership, (ii) the transferor's allocable share of ECI was both (A) less than 10% of the transferor's total distributive share of the partnership's net income and (B) less than $1 million, and (iii) the transferor's distributive share of ECI has been reported on a U.S. federal income tax return and all amounts due with respect to such income have been paid.
- The transferor certifies that a nonrecognition provision applies to the gain realized by the transferor and describes the provision's application. If only a portion of the gain is subject to a nonrecognition provision, the amount required to be withheld by the transferee may also be adjusted accordingly.
- The transferor certifies that it is not subject to tax on any gain from the transfer pursuant to a U.S. income tax treaty.
Similarly, the proposed rules provide that a transferee's withholding obligation may be reduced if the transferor provides a certificate demonstrating the transferor’s maximum tax liability that it owes on its ECI-related gain from the transfer.
When a partnership makes a distribution on a partnership interest, the partner receiving the distribution is treated as having made a transfer of a partnership interest and the partnership is treated as the transferee of the interest. A partnership must therefore generally withhold on distributions under Section 1446(f) except to the extent one of the exceptions above applies.
A reduction in a transferor's share of partnership liabilities is ordinarily treated as part of the transferor's amount realized under general partnership tax principles. Because this information may not readily be available to the transferee, the proposed regulations generally allow the transferee to rely on a certification from the transferor as to the amount of the transferor's share of partnership liabilities reported on the transferor's most recently received Schedule K-1, provided that the last day of the partnership taxable year for which the Schedule K-1 was provided was no more than 22 months before the date of transfer and the transferor is not a controlling partner of the partnership. A transferee may also rely on a certification from the partnership regarding the transferor's share of liabilities, but the partnership must make its determination of the transferor's partnership liabilities as of the transfer date (or, because it may be difficult to make certain computations as of the precise date of a transfer, as of a specific "determination date" in the same taxable year as the transfer and determined under rules set forth in the proposed regulations).
The proposed regulations also require a transferee to certify to the partnership that it qualifies for an exception to withholding or has properly withheld the amount required under Section 1446(f)(1).
Partnership Withholding on Distributions to Transferees Who Failed to Withhold
The proposed regulations would end the suspension of a partnership's obligation to withhold on distributions to a transferee on any amount that the transferee failed to properly withhold under Section 1446(f) and provide rules that would implement the partnership's withholding requirement, plus any interest on this amount.
In determining whether any withholding is required, the partnership may rely on the transferee's certification that it properly withheld. In limited circumstances, the IRS may require the partnership to withhold if the IRS has determined that the transferee has provided incorrect information on the certification or that the transferee failed to pay the amounts reported to the IRS.
A partnership that does not receive, or is not entitled to rely on, a timely certification from a transferee stating that an exception to withholding applies or that the proper amount has been withheld generally must withhold on the entire amount of each distribution made to the transferee until it receives a valid certification or the entire amount that the transferee failed to properly withhold (determined without taking into account certain adjustments that might have reduced the transferee’s withholding liability) has been withheld.
Under the proposed rules, a transferee remains liable for its withholding obligation even when the partnership is required to withhold as described below, but the transferee is treated as satisfying this withholding tax liability to the extent that the partnership withholds from such partner's distributions. If the amount of tax withheld from the transferee exceeds its withholding liability, only the partnership may claim a refund on behalf of the transferee for the excess amount. The preamble to the proposed regulations explains this rule is meant to make the refund process more administrable by having the partnership act on behalf of each of its transferee partners for purposes of claiming any excess amounts withheld by the partnership. The Treasury Department and the IRS anticipate that partnerships and transferees will make arrangements by contract so that the transferees may be reimbursed for amounts refunded to the partnership and have requested comments on this issue.
These rules do not apply when the partnership itself is treated as the transferee as a result of making a distribution. In that case, the partnership remains liable for any failure to withhold solely in its capacity as a transferee but may generally rely on its books and records to determine whether it is required to withhold.
As described in more detail below, these rules generally do not apply to distributions to a transferee of a PTI in a PTP.
Withholding on Transfers of PTIs in PTPs Through a Broker
The proposed regulations would end the suspension of Section 1446(f) withholding on the disposition of PTIs in PTPs provided in Notice 2018-08. If the transfer of a PTI in a PTP is not effected through one or more brokers, the general rules applicable to non-PTIs, discussed above, apply to the transaction. But the proposed regulations provide new rules where the transfer of a PTI in a PTP is effected through one or more brokers, imposing the responsibility for withholding on the brokers rather than on the transferee.
Generally, a broker that pays the amount realized from the transfer of a PTI in a PTP to a foreign broker must withhold unless the foreign broker is a qualified intermediary that assumes primary withholding responsibility or a U.S. branch of a foreign person that agrees to be treated as a U.S. person with respect to any applicable payment. Additionally, a broker that effects the transfer for the transferor as its customer is required to withhold. In no event is a broker required to withhold if it knows that the withholding obligation has already been satisfied. The proposed regulations also provide rules coordinating which broker or brokers have obligations in the case of transactions involving multiple brokers.
For this purpose, a broker is any person that in the ordinary course of a trade or business stands ready to effect sales made by others, and that, in connection with a transfer of a PTI in a PTP, receives all or a portion of the amount realized on behalf of the transferor. A broker also includes any clearing house that effects a transfer on behalf of the transferor. A transfer that is effected through a broker includes a distribution with respect to a PTI in a PTP held through an account with a broker.
In the case of a transfer of a PTI in a PTP, the proposed regulations generally do not require withholding by a broker in the following circumstances:
- The transferor provides the broker with a certificate of non-foreign status, including for this purpose a valid Form W-9. In cases where the transferor is a foreign partnership, the partners of the transferor may certify their non-foreign status, and the withholding amount may be reduced, based on the percentage of gain allocable to the non-foreign partners.
- The PTP posts a qualified notice stating that, if the partnership sold all of its assets at fair market value, the amount of gain constituting ECI would be less than 10% of the total net gain.
- In the case of a distribution made by the PTP, the PTP posts a qualified notice indicating that such distribution does not exceed the net income of the PTP earned since the record date of the PTP's last distribution.
- The amount realized by the transferor is subject to backup withholding under Section 3406.
- The transferor certifies that it is not subject to tax on any gain from the transfer pursuant to a U.S. income tax treaty.
While a reduction in a transferor's share of a partnership liabilities is ordinarily treated as part of a transferor's amount realized, the amount of gross proceeds paid or credited to the customer (or another broker) is treated as the amount realized for purposes of determining the amount realized on a transfer of a PTP interest (due to the difficulties involved with requiring a broker to determine such liabilities with respect to a PTP interest). Similarly, in the case of a distribution by a PTP, the amount realized is the amount of cash distributed plus the fair market value of any property distributed.
A PTP is generally not required to withhold in the event a transferee or broker, as applicable, fails to comply with these withholding obligations. However, when a PTP has published a qualified notice stating that withholding is not required with respect to a distribution, and the PTP or the IRS later determine otherwise, the PTP must withhold on distributions to transferees in an amount equal to the amount that any brokers failed to withhold due to reliance on the qualified notice, plus interest.
The proposed regulations also, among other things,
- provide reporting and notification rules that facilitate the transfer of information between a foreign partner and the partnership for purposes of computing the tax liability of a foreign partner under Section 864(c)(4),
- make certain changes to the qualified notice rules applicable to PTPs, publicly traded trusts, and real estate investment trusts, and
- provide rules coordinating withholding under Section 1446(f) and Section 1445 (FIRPTA)--in particular, if a transferee is required to withhold on the transfer of a partnership interest under Section 1445, the transferee will generally be required to withhold only under Section 1445 rather than Section 1446(f).
If you have questions regarding these proposed regulations, please contact any of the authors of this update.
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