Congress reacted swiftly to the Tax Court decision holding that no withholding tax should be imposed on the disposition of a partnership interest by a non-US investor in a partnership that was engaged in the conduct of a US trade or business.1 About five months after the decision, Section 13501 of the Tax Cuts and Jobs Act overturned that holding and mandated withholding on such dispositions through new Tax Code Section 1446(f).2 But, as any tax professional knows, the devil is in the details, and the congressional mandate requires substantial guidance in order to be executed properly. On October 7, 2020, the Internal Revenue Service (the “IRS”) released final regulations (the “Final Regulations”) under Section 1446(f) implementing the withholding obligations with respect to dispositions of interests in partnerships engaged in a trade or business within the United States by non-US persons.3 The Final Regulations generally retain the architecture of the proposed regulations published on May 13, 2019 (the “Proposed Regulations).4 Separate rules are provided with respect to dispositions of interests in non-publicly traded partnerships (“non-PTP interests”) and dispositions of interests in publicly traded partnerships (“PTP interests”). This Legal Update provides an overview of the Final Regulations and highlights departures from the Proposed Regulations.
Section 1446(f) generally requires a transferee of a partnership interest to deduct and withhold a tax equal to 10% of the amount realized on the disposition of such interest if any portion of the gain would be treated as effectively connected with the conduct of a trade or business within the United States (“ECI”). Effectively, withholding under Section 1446(f) is an enforcement mechanism for liability imposed under Section 864(c)(8).
Given the complexities of applying the withholding rules to PTP interests, the IRS released Notice 2018-18, which temporarily suspended the requirement to withhold on amounts realized in connection with the sale, exchange or disposition of PTP interests. The IRS also released Notice 2018-29 which provided temporary guidance and announced an intent to issue proposed regulations with respect to the sale, exchange or disposition of non-PTP interests and, subsequently, the Proposed Regulations.
Consistent with the Proposed Regulations, the Final Regulations generally require withholding under Section 1446(f) on a transfer of a partnership interest by a non-US investor in a partnership that is engaged in a US trade or business unless an exception or adjustment to withholding applies. In other words, the rules require a transferee to presume that a transfer is subject to such withholding unless the transferee obtains a certification establishing otherwise (or in the case of a partnership making a distribution, by relying on its books and records to make such determination).
The Final Regulations seemingly attempt to ease the burden imposed by the general rule by providing an overarching exception to withholding (in addition to the listed exceptions applicable to non-PTP and PTP interests, each discussed below), which alleviates a person’s liability for otherwise failing to withhold under Section 1446(f) if such person establishes, to the satisfaction of the IRS, that a transferor had no gain under Section 864(c)(8) with respect to a transfer of a partnership interest. However, it is unclear how this exception will apply in practice.
For example, if a transferor transfers its non-PTP interest in a partnership that is not engaged in a US trade or business, but the partnership declines to issue a certification stating that it is not engaged in a US trade or business under the “10-percent effectively connected gain exception” (discussed below) and no other listed exception applies, it appears that this overarching exception may nevertheless apply if it can be established, to the satisfaction of the IRS, that the transfer of the interest has not generated gain that is treated as ECI. However, the procedures and documentation required for this exception remain undefined, so it is unclear how and whether a taxpayer can rely on this exception to avoid such withholding in practice.
As explained above, the general mechanics of Section 1446(f) require a transferee of a partnership interest to deduct and withhold a tax equal to 10% of the amount realized on the disposition of such interest, unless certain exceptions apply.
The amount realized (i.e., the amount from which the transferee must withhold) with respect to a transfer of a partnership interest is generally determined under normal tax rules and includes relief from partnership liabilities (whether or not recourse). Thus, as confirmed in the Final Regulations, such calculation takes into account any reduction in the transferor’s share of partnership liabilities.
For purposes of determining the amount realized when the transferor is a foreign partnership, the Final Regulations adopt the position taken by the Proposed Regulations to generally limit the amount of withholding to the portion of the amount realized attributable to partners presumed to be non-US persons, which include any direct or indirect partners that have not certified their status as a US person. To claim this reduced withholding, the foreign partnership transferor would provide the transferee with a Form W-8IMY, a withholding statement allocating gain to each partner, and a certification of US status (e.g., a Form W-9) for each partner that is treated as a US person.
Consistent with the new treaty exceptions discussed below, the Final Regulations clarify that the amount subject to withholding will be reduced to the extent any non-US partner in the foreign partnership is eligible for treaty benefits (i.e., a non-US partner eligible for treaty benefits is not presumed to be a non-US person for purposes of calculating the amount realized).
Exceptions to Withholding
The Final Regulations generally adopt the six exceptions to withholding described in the Proposed Regulations, with certain modifications.
- The “non-foreign status exception” requires the transferor to certify its status as a US person (e.g., by providing the transferee with a Form W-9). The preamble to the Final Regulations confirms that qualified foreign pension funds (“QFPFs”) are foreign persons for purposes of Section 1446(f). Thus, the non-foreign status exception is not available to QFPFs.
- The “no realized gain exception” requires the transferor to certify that the transfer would not result in any realized gain, including any ordinary income arising under Section 751(a) (even if there is overall loss on the transfer).
In making such certification to the transferee, the Final Regulations clarify that the transferor may rely on a certification from the partnership confirming that, as of the determination date, the transfer would not result in ordinary income under Section 751(a) (which the transferor would attach to its certification provided to the transferee).
- The “10-percent effectively connected gain exception” requires the partnership to certify that if it were to sell all of its assets at fair market value, the amount of net effectively connected gain resulting from the deemed sale would be less than 10% of the total net gain. In the case of a partnership distribution, the partnership may rely on its books and records in making such determination.
The Final Regulations clarify that a transferee may also rely on a certification confirming that the transferor’s distributive share of net effectively connected gain from the partnership would be less than 10% of the transferor’s distributive share of the total net gain from the partnership. However, the Final Regulations also retain the rule permitting partnerships to make such determination at the partnership level without regard to the transferor’s distributive share of net ECI.
Moreover, the Final Regulations expand the “10-percent effectively connected gain exception” by allowing transferees to rely on a certification from the partnership that the partnership was not engaged in a trade or business in the United States at any time during the taxable year of the partnership through the date of transfer.
- The “10-percent ECI exception” requires the transferor to certify that (a) it was a partner in the partnership at all times in the three immediately prior taxable years; (b) the transferor’s distributive share of gross ECI, as reported on Schedule K-1, (including such amounts allocated to persons related to the transferor) was less than $1 million for each such year; (c) the transferor’s distributive share of gross ECI, as reported on Schedule K-1, was less than 10% of the transferor’s total distributive gross income from the partnership for each such year; and (d) for each of the three preceding years, the transferor’s distributive share of partnership gross ECI or losses has been (or will be) timely reported on a federal income tax return and, to the extent of any amount due, paid.
The Proposed Regulations required the transferor to certify that the transferor’s allocable share of effectively connected taxable income (“ECTI”) was less than 10% of the transferor’s total distributive share of net income and less than $1 million in each such year, as reflected on the transferor’s Form 8805 (unless the transferor was allocated effectively connected losses, in which case, the transferor would have an allocable share of ECTI of zero). Under this approach, there was a concern that a foreign partner that did not receive Form 8805 would not be able to rely on this exception even if such foreign partner did not recognize any ECTI through the partnership. The Final Regulations, therefore, modify this exception such that a foreign partner that is not allocated any ECI could still qualify for this exception as long as it receives Schedule K-1s for the three immediate prior tax years. While this modification is helpful, the Final Regulations still fail to address the situation where foreign partners in a partnership do not receive Schedule K-1s because the partnership takes the position that it is not required to deliver Schedule K-1s to its partners.
- The “certification of nonrecognition exception” requires the transferor to certify that a nonrecognition provision of the Code applies to all of the gain realized on the transfer together with a brief description of the transfer and the relevant law and facts relating to the certification.
- The “claim for treaty benefits exception” requires the transferor to certify that it is not subject to tax on any gain from the transfer by reason of an income tax treaty between the United States and a foreign country. The Final Regulations confirm that Form W-8BEN or W-8BEN-E, as applicable, may be used to make such claim for benefits under an income tax treaty. The IRS intends to revise the instructions to Forms W-8BEN and W-8BEN-E to describe the information required to be provided for making a treaty claim for purposes of Section 1446(f).
Consistent with the Proposed Regulations, to the extent a transferee fails to withhold under Section 1446(f)(1), the Code imposes secondary liability on the partnership by requiring the partnership to deduct and withhold from future distributions to the transferee an amount equal to the amount the transferee failed to withhold, including interest. The partnership determines its withholding obligations, if any, with respect to a transferred partnership interest by reference to the information provided by the transferee on its certification of withholding, which includes the underlying certification the transferor provided to the transferee (unless the partnership knows, or has reason to know, that such information is incorrect or unreliable).
The transferee is required to provide its certification of withholding to the partnership within 10 days after the transfer (and deposit any tax due arising under Section 1446(f)(1) within 20 days after the date of the transfer). If the partnership does not receive the transferee’s certification of withholding, or the partnership cannot rely on the certification, the partnership is required to withhold on the entire amount of each distribution made to the transferee until a valid certification is provided and the partnership is able to conclude the Section 1446(f) liability has been satisfied.
The Final Regulations attempt to ease the administrative burdens of this rule by allowing the partnership to determine it has no withholding obligation under Section 1446(f)(4) if the partnership already has in its files a valid Form W-9 establishing the transferor’s US status despite not having otherwise received a withholding certification from the transferee.
To the extent a partnership exercises its discretion to withhold pursuant to Section 1446(f)(4), the Proposed Regulations permitted only the partnership to obtain a refund for amounts overwithheld (i.e., amounts withheld by the partnership in excess of the transferee’s withholding liability on the initial partnership interest transfer). The Final Regulations reverse this rule by permitting the transferee, rather than the partnership, to obtain any such refund (and applicable interest). More specifically, the Final Regulations eliminate the partnership’s ability to claim a refund on behalf of the transferee for such amounts.
However, as discussed above, a transferee’s Section 1446(f) withholding tax liability is not satisfied if the partnership knows, or has reason to know, that the certification the transferee relied on to reduce or eliminate withholding is incorrect or unreliable. Thus, if the partnership has additional information that conflicts with the withholding certification the transferor provided to the transferee (on which the transferee relied to reduce or eliminate Section 1446(f) withholding), the transferee may be barred from claiming a refund for any amounts it believes the partnership overwithheld under Section 1446(f)(4).
Moreover, the Final Regulations generally do not require a partnership that is otherwise required to withhold on distributions made to a transferee under Section 1446(f) to continue such withholding after the transferee transfers its interest to another person (i.e., a subsequent transferee), unless the partnership has actual knowledge that the subsequent transferee is related (within the meaning of Sections 267(b) or 707(b)(1)) to the transferee or the initial transferor. The Final Regulations clarify that in such case, the related person remains liable, pursuant to Section 1461, for the withholding imposed on the transferee. Effectively, this prevents a related person from claiming a refund for amounts the partnership otherwise properly withheld under Section 1446(f)(4).
Qualified Intermediaries (“QIs”) and Non-Qualified Intermediaries (“NQIs”)
The preamble to the Final Regulations confirm that Treasury and the IRS plan on updating the QI Agreement (Rev. Proc. 2017-15) to allow QIs to assume primary withholding responsibilities on amounts realized under Section 1446(f) and on distributions by PTPs under Section 1446(a). That said, QIs will not be obligated to assume such responsibilities. Thus, a QI’s determination as to whether it should or should not assume such responsibilities should be made after appropriate consideration of the terms of the revised QI Agreement when it becomes available. Provisions related to the Final Regulations applicable to QIs are expected to be incorporated in the new QI Agreement that will take effect in 2023.
The IRS indicated that its current intention is to publish a rider to the current QI Agreement to set forth a QI’s obligations with respect to Section 1446 for calendar year 2022. In addition, the preamble to the Final Regulations state that a QI will not be required to conduct a periodic review with respect to compliance with Sections 1446(a) and 1446(f) for the 2022 calendar year and, therefore, the rider will not include any review procedures for these sections. That said, QIs will ultimately need to wait to see precisely how Section 1446 is incorporated into the forthcoming QI Agreement to determine its obligations.
With respect to NQIs, we wanted to highlight that the Final Regulations require a broker to withhold the full 10% of the amount realized on transfers of PTP interest when paid to an NQI, even in situations where the NQI is acting on behalf of US persons or foreign persons that are eligible for an exemption from withholding. Account holders of an NQI may be entitled to claim a credit for overwithholding. This point should be considered when deciding how to structure an investment in a PTP.
The Proposed Regulations would have treated clearing organizations that effect the transfer of PTP interests as “brokers,” and would have required them to withhold under the rules described above. In the preamble to the Final Regulations, the IRS noted that it had received comments requesting various exclusions and special rules regarding brokers effecting trades cleared and settled at a clearing organization. One of these comments highlighted the critical role of clearing organizations in ensuring the functioning of US capital markets and suggested that imposing this requirement on clearing organizations would be disruptive to the market for PTP interests. The comment additionally noted that clearing organizations frequently process securities trades through a netting system, which could have been severely impacted by gross basis withholding under Section 1446(f).
While the Final Regulations define a broker as including a clearing organization, the Final Regulations provide that US clearing organizations need not withhold on trades of PTP interests that are netted and that have a US clearing organization as the central counterparty.
However, to ensure that withholding on sales of PTP interests sold through a netting process at a US clearing organization is satisfied by the member brokers and that there are no NQIs participating in the net settlement system, US clearing organizations must report such sales on a non-netted basis on Form 1042-S unless an exception applies. The Final Regulations indicate that while there are currently no NQIs that participate as direct clearing members in the net settlement system in any US clearing organization, if this changed, the IRS would propose regulations that would require withholding on such NQIs.
The IRS also received comments requesting the IRS adopt an approach similar to Section 6045 (i.e., reporting by brokers of gross proceeds from sales of securities). Specifically, comments requested that in the case of a delivery versus payment (“DVP”) transaction, for purposes of Section 1446(f), only the custodian for the seller should report and withhold on the sale, and not the broker paying the gross proceeds to the custodian. The comment noted that without such a rule for Section 1446(f), certain brokers that are not currently documenting and reporting payments of gross proceeds for purposes of Section 6045 would be required to create systems to document and, if necessary, withhold on and report payments to a custodian holding a PTP interest on behalf of a transferor and receiving the amount realized for purposes of Section 1446(f). Treasury and the IRS did not accept these recommendations and the Final Regulations generally require brokers to withhold on payments of amounts realized on PTP transfers to foreign custodians, including payments made with respect to DVP transactions. In an effort to address industry concerns relating to documentation, the Final Regulations allow a US clearing organization to provide tax documentation received by one of its member brokers to another member broker (so long as certain notification procedures are satisfied).
PTP Withholding Under Section 1446(f)
The Final Regulations eliminate the requirement in the Proposed Regulations that a PTP withhold on distributions to a transferee. Under the Proposed Regulations, a PTP was required to withhold under Section 1446(f)(4) on distributions to a transferee if it posted a “qualified notice” (discussed below) that falsely stated certain exceptions applied and the broker relied on the notice to reduce or eliminate such withholding. In response to comments raising concerns with secondary liability, the Final Regulations provide that PTPs no longer have a withholding obligation on future distributions to a transferee under Section 1446(f), even where a broker fails to withhold based on a false qualified notice. To the extent a broker properly relies on a qualified notice, the Final Regulations instead impose liability for any such underwithholding on the PTP pursuant to Section 1461. However, this liability only applies if the PTP fails to make a reasonable estimate of the amounts required for determining the availability of the 10-percent exception (discussed below) to withholding.
Consistent with the Proposed Regulations, any broker that effects a transfer of a PTP interest on behalf of a non-US partner and receives the amount realized on behalf of the transferor is generally required to withhold a tax of 10% of the amount realized. As with non-PTP interests, the Proposed Regulations similarly provided a list of exceptions to this withholding requirement. The Final Regulations generally adopt the framework of the Proposed Regulations, with certain modifications.
- The “certification of non-foreign status exception” requires the transferor to certify its status as a US person (e.g., by providing a Form W-9).
- The “10-percent exception” permits a broker to rely on a “qualified notice” posted by the PTP certifying that if the PTP sold all of its assets at fair market value, either (a) the gain that would have been effectively connected with the conduct of a US trade or business would be less than 10% of the total net gain or (b) no gain would have been effectively connected with the conduct of a US trade or business.
The Final Regulations expand this exception such that a broker may also rely on a qualified notice certifying that the partnership was not engaged in a US trade or business at any time during the taxable year of the partnership through the PTP designation date, which must be no more than 92 days before the date of the transfer. The Final Regulations did not lengthen this period to 183 as suggested in taxpayer comments.
- The “amounts subject to withholding under Section 3406 exception” provides that a broker is not required to withhold if the amount realized on the transfer of the PTP interest is subject to backup withholding.
- The “income tax treaty exception” requires the transferor to certify that it is not subject to tax on any gain from the transfer by reason of an income tax treaty between the United States and a foreign country. A Form W-8BEN or W-8BEN-E, as applicable, may be used to make such certification.
- The Final Regulations also add a new “ECI exception,” which requires the transferor to certify that it is a dealer in securities and that any gain from the transfer of the PTP interest is effectively connected with a US trade or business without regard to Section 864(c)(8). A Form W-8ECI may be used to make this certification.
Note that the Final Regulations removed entirely the exception for withholding on qualified current income distributions by a PTP. Under the Proposed Regulations, in the event a distribution by a PTP was treated as a transfer for purposes of Section 1446(f), the entire amount of the distribution would have been treated as the amount realized. The Proposed Regulations provided an exception to the broker’s requirement to withhold on such distributions if the partnership designated the distribution in its qualified notice as a qualified current income distribution (i.e., a distribution that does not exceed the net income of the PTP since the date of the last distribution).
In response to numerous comments, the Final Regulations modify this rule to provide that a broker is only required to withhold on the portion of a distribution attributable to an amount in excess of cumulative net income, rather than current net income. Under the Final Regulations, the PTP would need to identify this portion on a qualified notice.
The Final Regulations are generally applicable to transfers that occur 60 or more days after the Final Regulations are published in the Federal Register. However, certain extensions are provided. In particular, the provisions relating to transfers of PTP interests will only apply to transfers that occur on or after January 1, 2022. Moreover, withholding required under Section 1446(f)(4) by partnerships on distributions made to transferees that otherwise fail to withhold under Section1446(f) will only apply to transfers occurring on or after January 1, 2022.
3 T.D. 9926. The Final Regulations are available at https://www.irs.gov/pub/irs-drop/td-9926.pdf.
4 For a summary of the Proposed Regulations, please see our Legal Update “IRS Issues Proposed Regulations Regarding Withholding Under Section 1446(f)” available at https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2019/06/proposed-1446f-regulations.pdf.